Testing Swensen
Measuring the Value Added by Alternative Assets
within the Investment Pools of Non-profit Organizations
Jon M. Luskin
A thesis submitted
in partial fulfillment of the requirements for the degree
Master of Business Administration
American Jewish University
2013
Jon Luskin - MBA Thesis v4.docx Page 2
Signature Page
The thesis of Jon M. Luskin is approved.
__________________________________ ____________
Larry Weinman, MBA date
__________________________________ ____________
Seth Weintraub, MBA, CMA date
__________________________________ ____________
Gerald J. Wacker, Ph.D. date
Jon Luskin - MBA Thesis v4.docx Page 3
Dedication
To my family, for their support
Jon Luskin - MBA Thesis v4.docx Page 4
Table of Contents
Acknowledgements ..............................................................................................................6
Abstract ................................................................................................................................7
Chapter 1: Introduction ........................................................................................................8
Scope ........................................................................................................................8
Orientation ...............................................................................................................8
Personal Background .............................................................................................10
Conceptual Framework ..........................................................................................10
Chapter 2: Literature Review .............................................................................................19
Overview ................................................................................................................19
Summary of Major Sources ...................................................................................19
Methodology ..........................................................................................................20
Overall Summary and Comparison ........................................................................20
Critique ..................................................................................................................21
Point of Departure ..................................................................................................22
Chapter 3: Empirical Study Method ..................................................................................23
Hypotheses .............................................................................................................23
Background of the Data Source .............................................................................24
Procedure Used to Collect Data .............................................................................24
Advantages and Disadvantages of this Method .....................................................24
Chapter 4: Findings ............................................................................................................26
California Social Services Organization ................................................................27
University of Hawaii Foundation...........................................................................30
Washington State University Foundation’s Endowment Fund ..............................33
University of Northern Carolina, Wilmington .......................................................35
University of California, Santa Barbara Foundation .............................................37
University of California, Irvine Foundation ..........................................................39
University of California, Riverside Foundation.....................................................41
University of California, San Francisco Foundation .............................................43
Chapter 5: Conclusions ......................................................................................................45
Theoretical Insights ................................................................................................45
Practical Recommendations ...................................................................................47
What this Study Adds to the Literature ..................................................................51
Suggestions for Future Research ...........................................................................51
Works Cited ...........................................................................................................52
Appendices .........................................................................................................................57
Appendix A: Indexing vs. Active Management ....................................................58
Appendix B: Risk-Free Rate ..................................................................................62
Appendix C: Basic Investing Principles Glossary .................................................63
Appendix D: 60/40 Benchmark .............................................................................66
Jon Luskin - MBA Thesis v4.docx Page 5
Appendix E: Digest of the Literature .....................................................................67
Appendix F: CSSO Net of Fees Estimate ..............................................................99
Appendix G: CSSO’s Problematic Portfolio .......................................................101
Jon Luskin - MBA Thesis v4.docx Page 6
Acknowledgements
This work would not have been possible without the contribution of many individuals.
My father helped me clarify some of the more complex points for lay readers. My fiancé
took the time to edit the document, even though she was busy studying for her CPA
exams. My thesis advisor, Dr. Gerry Wacker, graciously took the time to meet with me
on many occasions. Seth Weintraub, a thesis reader, taught a stimulating course at
American Jewish University that further ignited my interest in finance. Larry Weinman,
another thesis reader, helped by explaining various investment principles and enlightened
me on the easiest way to calculate investment returns. Steven Vielhaber not only
discussed my findings with me, but also introduced me to Regina Fales, who introduced
me to David F. Prenovost, who continually worked to help me find the appropriate data.
Kristin Fong took the time to meet with me and supply me with data for this study. Paul
Castro and Trent Maggard gave their time as well. A final ‘thank you’ goes to Adam
Luskin and Sarah Sypniewski for their superb editing.
Jon Luskin - MBA Thesis v4.docx Page 7
Abstract
Over the last few decades, many institutional investors, such as university endowments,
have jumped on board a new investing bandwagon: alternative assets. Why? Ivy League
endowments – with elite money managers at the helm – have posted extremely
impressive risk-adjusted portfolio returns using alternative assets.
Alternatives are those investments that are not investments in stocks, bonds or
cash. This asset class includes a wide range of investments, including hedge funds, oil &
gas, timberland, real estate, venture capital, mergers and acquisitions, and even fine art.
There is no accurate indexing option for alternative assets. To invest in alternatives,
active management is required.
Previous studies have demonstrated that university endowments can often yield
higher investment returns through index-based investing strategies as opposed to
actively-managed alternative investments. Put simply, low-cost indexing produces higher
returns. Only the largest institution can afford to retain the best money managers.
Therefore, the best investment strategy is to retain those managers. The second-best
strategy is to hold an inexpensive index fund. The worst strategy is active management
by a pedestrian money manager.
These studies omit one critical variable: risk. A basic tenet of investing that is
higher investment return can only be realized by subjecting principal to higher risk.
While the index fund may post a higher a return, it may also subject the investment to
higher risk. These studies failed to measure risk-adjusted performance.
This study seeks to examine the value of holding alternative assets without
management by elite professionals. Metrics for consideration include not just total return,
but volatility (standard deviation), risk-adjusted performance (Sharpe Ratio), risk-
adjusted performance above a minimum threshold (Sortino Ratio), and investment
performance in years of market shock – including the bursting of the tech bubble and the
sub-prime crisis.
Eight case studies are considered, measuring the value of alternative assets.
Results show that index-based portfolios not only produced higher returns, but it did so
with less volatility (risk) and exhibited superior performance during market shocks.
Endowments allocating to alternatives should carefully re-evaluate their investment
strategies.
Jon Luskin - MBA Thesis v4.docx Page 8
Chapter 1: Introduction
Scope
Without perceived sufficient in-house expertise, non-profit organizations often transfer
management of their multi-million dollar investment pools to outside firms (Jones and
Martinez 2013). These firms often put the non-profit’s funds into expensive and complex
investment vehicles.
Impressed with the returns of the Ivy League investment pools, and persuaded by
professional money managers, non-profit boards and executives are allocating
increasingly larger portions of their investments to alternative assets (National
Association of College and University Business Officers and Commonfund Institute
2012). Yet in the absence of Ivy League resources (i.e. access to top-decile
1
money
managers), these non-profits are witnessing inferior investment returns – most certainly
less than could be had by holding a basket of diversified index funds (Ferri 2012,
Wallick, Wimmer and Schlanger 2012). The reason for this poor performance is that
smaller institutions simply do not have the scale to reward truly skilled investments
managers with millions of dollars in compensation.
Further, while the Ivy League endowments have previously consistently posted
superior investment returns, recent performances have been inconsistent (Yale
Endowment 2012, Mendillo 2012). This is in part because the once inefficient market for
alternatives has grown increasingly competitive as more imitators crowd into the
marketplace.
Given the asset class’s poor performance record, what is the reason for this
allocation to alternatives? This paper seeks to evaluate the risk-adjusted return of holding
alternative assets when not managed by top-decile professionals. In the empirical study to
follow, eight non-profit investment pools with assets under management (AUM) under $1
billion are evaluated. Investment performance is juxtaposed against a portfolio absent of
alternative assets.
Orientation
With hundreds of millions of dollars on the line, a foundation’s annual investment return
determines exactly how much the charitable organization can do each year. Higher
investment returns mean more grants, meals served, scholarships made available, or
medication distributed. Choosing the best investment strategy greatly impacts achieving
an organization’s mission.
1
The top-decile being those investment managers above the 90
th
percentile with respect to
creating risk-adjusted return.
Jon Luskin - MBA Thesis v4.docx Page 9
One investment strategy in particular, the utilization of active management,
2
makes the promise of stock market-beating returns. However, actively-managed funds
fail to beat their respective benchmark over 90% of the time (Bogle 2007; Malkiel 2012;
Swensen; Bernstein 2010; Stanyer 2010). In the likely event of poor investment
performance, investors are still liable for paying expensive management fees. These fees
for actively-managed investments can reach two percent annually – sometimes more.
3
With non-profits’ using investment gains to fund programming, market
underperformance by two percent can mean cutting back on programming services for
the year. A two percent loss compounded over 10 years can mean shutting down entire
departments.
Figure 1 - $31,000,000 Difference on a $100,000,000 Investment
Given the poor track record of active management, why are non-profits putting increasing
proportions of their money into alternative investments? Non-profit executives and board
members do not believe they have the skill set to invest the money themselves.
4
Thus,
they outsource the role to professional money managers. However, for many
organizations, their limited assets of only several hundred million dollars preclude them
from being able to hire the best of the best: the top-decile money manager.
Thus, these organizations hire average money managers, who pitch the value of
diversification in holding exotic alternative investment products (McCrum 2013).
However, performance data of alternative endowment investments has shown the returns
2
Alternatives are a type of actively-managed asset. Conventional assets can also be actively
managed. The distinction between the two is covered in a following section The Endowment
Model and Alternative Assets.
3
Hedge funds are an example of this. Hedge funds typically have a 2 and 20 fee structure. This is
where fund management claims 2% of all AUM, and then another 20% on top of any gains.
4
As I will show in this paper, this is not the case. A simple index-based strategy is easy to
execute. Any CFO could more than manage the task.
$179,084,770
$148,024,428
$100,000,000
$110,000,000
$120,000,000
$130,000,000
$140,000,000
$150,000,000
$160,000,000
$170,000,000
$180,000,000
$190,000,000
1 2 3 4 5 6 7 8 9 10
Investment Value
Period (Years)
6% Return Compounded
4% Return Compounded
Jon Luskin - MBA Thesis v4.docx Page 10
offered by active management are usually less than what could be had with indexing
(Ferri; Wallick, Wimmer and Schlanger).
If studies have already proven the superior returns of indexing over average active
management within non-profit investment pools, why does active management still exist?
Why do boards of non-profit organizations and finance committees - staffed by
seemingly knowledgeable, competent professionals - continue to invest in a failed
strategy?
One reason is the just-mentioned value of diversification. Maybe these poorer
performing alternative assets help a portfolio produce superior risk-adjusted returns. That
is, for the level of risk involved, adding alternatives creates a better investment. Including
actively-managed alternatives (even when managed by average money managers) may
offer a way to reduce risk and even achieve superior risk-adjusted returns because of low
correlation to market events.
Personal Background
Prior to my research for this project, my personal investment strategy consisted of
chasing temporally high-flying mutual funds. Such behavior was egged on by broker
suggestions, who neglected to mention the issue of volatility. Never once did a broker
say, “your limited assets prevent you being able to hire a manager who can beat the
market after the cost of fees. It is those fees – in the absence of superior performance –
that will eat away at returns. Your best bet is to buy and hold the lowest cost index fund
available.”
If this simple advice was not available to me, with my small retirement portfolio,
what chance is there that an outside adviser would suggest the same to a non-profit
organization, especially when there are literally millions of dollars in fees on the line?
Conceptual Framework
Non-profit and governmental organizations have billions in invested assets. Much of this
wealth is concentrated in educational endowments and pension funds, respectively.
Historically, most of these funds were invested in a mix of corporate stock and
government bonds. However, within the last few decades, a shift in investment strategy
has occurred (Ezra 2012, Swensen). Before this paper covers the consequence of that
shift in detail, an investing primer follows. Readers already familiar with the basic tenets
of Modern Portfolio Theory (MPT), diversification and correlations, and the endowment
model and alternative assets, can skip to section Questions to Be Addressed in This Thesis
on page 16. For a primer on indexing and active management, see Appendix A: Indexing
vs. Active Management on page 58.
Correlation & Modern Portfolio Theory
Correlation is the extent to which one asset’s performance mimics another asset’s
performance. Consider an example: Investment A increases in value by 100%.
Investment B increases in value by 50%. Investments A and B are said to have a
correlation of 0.5. For every increase (or decrease) Investment A undergoes, Investment
B undergoes ½ of that increase (or decrease).
Jon Luskin - MBA Thesis v4.docx Page 11
The following line graph, Figure 2 - Asset Class Correlation, illustrates
correlation.
5
Consider how the performance of the S&P 500 (blue) is highly correlated to
the performance of international companies (purple). The blue and purple lines rise and
fall simultaneously. When blue is up, purple is up. When blue is down, purple is down.
Thus, the performance of domestic equities (S&P 500) and international equities are
highly correlated.
Figure 2 - Asset Class Correlation
Conversely, long-term Treasuries are historically negatively correlated to the S&P 500
(Swensen). Note that in the graph, the long-term Treasuries (red) make opposite moves in
value relative to the S&P 500 (blue). When blue is up, red is down. When blue is down,
red is up.
Commodities theoretically exhibit little correlation to the other asset classes just
mentioned. Consider how commodities (green) rise and fall relatively independently of
the other asset classes.
According to Modern Portfolio Theory, a portfolio of investments performs best
when it is diversified among assets that have no correlation. Since every asset suffers
from periods of poor performance, diversification across uncorrelated asset classes
ensures consistent portfolio growth.
The Endowment Model and Alternative Assets
The strategy for institutional investors has changed over time. Before 1980, corporate
stock and government bonds (60/40) represented the norm. In the early 1980’s, a new
investing strategy came into fashion, dubbed the endowment model or Yale model (Ezra).
Under their Chief Investment Officer, David F. Swensen, Yale University gave birth to
the endowment model. Swensen pioneered this investment strategy, which received
attention for its consistent market-beating returns. Distinguishing Yale’s strategy from
traditional investment paradigms is its ever-increasing allocation to alternative assets
(2012 Yale Endowment).
5
These are the not the actual returns of the listed asset classes. The example is solely for
explanative purposes.
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
2.3
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Growth of Wealth
S&P 500
Long term Treasuries
Commodities
International
Jon Luskin - MBA Thesis v4.docx Page 12
Distinctions of Alternative Assets
Alternative assets are those investments outside of conventional stocks and bonds.
Alternatives include hedge funds, real estate, timberland, oil and gas, precious metals,
venture capital, merger and acquisitions, and fine art.
6
Alternative Investment Class
Strategy
Hedge Fund
Absolute Return
Oil & Gas
Real Assets
Timberland
Real Assets
Precious Metals & Mining
Real Assets
Real Estate
Real Assets
Venture Capital
Private Equity
Mergers & Acquisition
Private Equity
Fine Art
Speculative
Several distinctions separate alternatives from conventional assets. What follows are the
distinctions relevant to this study. (The breadth of content precludes a full discussion of
these distinctions.)
Correlation: Holding alternative assets can help diversify a portfolio. A lure of
alternative assets classes is their low correlation to conventional assets (Malkiel).
Recall the performance of commodities displayed in Figure 2 - Asset Class
Correlation on page 11. Put another way, what makes alternatives appealing is
the idea that their investment return is relatively independent of broad stock
market movements.
Inefficient Markets: Alternatives trade in inefficient markets. This in contrast to a
publicly-traded company, where information relevant to the company’s value is
readily accessible within seconds. The rapid availability of this information is
instantly reflected in that company’s share price. This is the opposite case for
alternative investments. Whereas information about the investment value of
conventional assets (e.g. a publicly-traded company) is widely accessible through
mass media, comparable information is not available for most alternative
investments (e.g. several acres of privately-held timberland). A truly skilled
money manager can exploit this information asymmetry for superior risk-adjusted
investment return. Recent crowding into these markets, however, has decreased
this potential (Humphreys). Therefore, the market for alternatives assets is
becoming increasingly efficient. This is reflected in the poorer investment returns
of Ivy League endowments relative to an indexed investment (Yale Endowment).
6
Fine art, like gold, is a speculative investment. Speculative investments depend solely on price
appreciation, providing no income (i.e. paying no dividend). No case study in this paper engaged
in fine art as an investment vehicle.
Jon Luskin - MBA Thesis v4.docx Page 13
Active management: Alternative assets require active management (Swensen
2009). Unlike conventional stocks and bonds, there exists no true index fund for
alternatives.
7
Illiquidity: Alternatives assets are those assets that trade in smaller, illiquid
markets. Whereas a share of Apple stock can be sold within a millisecond on the
New York Stock Exchange (NYSE) for the market price, transferring ownership
of a private company may take weeks or even months to execute. Such trading
illiquidity risk requires compensation; illiquid assets must sell at a discount
relative to liquid assets of equal value (Celati 2005).
For investment pools that have regular distribution requirements, illiquidity can be
problematic if significant allocations of an investment portfolio are illiquid. Consider
endowments providing operational support, pension funds, charitable foundations making
the required distribution of 5% annually, or even individual retirement portfolios that
provide for cost of living in the absence of other income. An over-allocation of illiquid
assets may mean that an investor is not able cash in the event of an emergency. This is
illiquidity risk: “risk of losses due to the need to liquidate positions to meet funding
requirements,” (Jorion 2012). Further, this liquidity risk is difficult to measure. Jorien
explains:
…liquidity risk creates a major problem for the measurement of risk. After
all, risk measures represent potential changes in market prices. If
historical prices do not change frequently enough, traditional risk
7
While there are some investment products that attempt to index alternatives, most fail in their
execution. Either these investments do no accurately track the price of the sector they intend to
mimic, or excess fee eat away at returns. Real estate is the exception. Many real estate
investments are available via inexpensive Real Estate Investment Trust (REIT) indices.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Level I Investment
Highly Liquid
Level II Investment
Relatively Illiquid
Market Price Relative Underlying Asset
Value
Illiquidity premium - Discount to
asset's underlying value
% of Asset's Underlying Value
Reflected in Market Price
Jon Luskin - MBA Thesis v4.docx Page 14
measures cannot be accurate. Worse, they will tend to underestimate the
true economics risks.
The infrequent measurement intervals of alternative assets grossly understate volatility
(risk). Risk-adjusted metrics therefore are less valuable when comparing liquid and
illiquid investments. It’s essentially an apples-to-oranges comparison. The more illiquid
an investment is, the more difficult it is to assess its volatility. When correcting for
infrequency of available data, one study has shown private equity to be more volatile than
conventional assets. Given this, the study’s authors deemed the asset classes unworthy of
investment (Conroy and Harris 2008)
Over allocating illiquid assets can be problematic. Consider that the recent sub-
prime crisis forced many endowments to sell assets at depressed levels (Humphreys).
Further, selling liquid assets ultimately increases the percent of illiquid assets in the
portfolio, exacerbating the illiquidity problem.
Types of Alternative Assets
Distinctions between the various types of alternatives assets are covered briefly below. A
full discussion is beyond the scope of this paper.
Hedge funds, using an absolute return strategy,
8
theoretically perform
independent of market movements. This is because hedge fund managers have the
ability to take either the position that an investment will appreciate in value (long)
or depreciate in value (short). This is different from traditional mutual fund
managers, who can only be long in a position. After accounting for the fees of
hedge funds – usually 2% of AUM and 20% of any investment return – data has
shown hedge fund managers have failed to beat the benchmark consistently
(Jorion, Swensen, Kolhatkar 2013). This is because most of hedge fund
investment successes are consumed as fees before that return ever makes its way
back to the investor (Bhardwaj, Gorton and Rouwenhorst). Further, hedge fund
managers dictate strict rules for divestment, imposing lockup and minimum
redemption notice periods (Swensen; Jorion). Such constrained exit liquidity –
“the speed with which one can liquidate the investment in a fund” – is risk
(Celati).
Real estate is considered an alternative asset because it is neither a stock nor
bond. When it comes to investing in real estate, there are several options. On the
inexpensive end of the spectrum and requiring the least manager skill is a Real
Estate Investment Trust (REIT) index fund. A REIT index gives an investor a low-
cost way to diversify across numerous real estate holdings. Edging closer to active
management, an investor may choose to select specific REITs, or may hire a
money manager via an actively-managed mutual fund to do so. Privately
managed, real estate is at the other end of the cost and liquidity spectrum.
8
Absolute return investment techniques involve using short selling, futures, options, derivatives,
arbitrage, leverage and unconventional assets.
Jon Luskin - MBA Thesis v4.docx Page 15
Master Limited Partnerships (MLPs) are investments in the petrochemical
transport infrastructure. (Diversification in MLPs can be achieved with
moderately-priced index funds.)
9
Commodities investments range from holding physical assets (like gold bullion) to
investing in a trust that holds gold for an investor, minus an ongoing fee. The
challenge for such an investment is that the commodity must appreciate in value
in excess of inflation to cover the cost of management, storage and transactions.
Because the asset does not produce income, a speculative commodity investment,
such as gold, is risky.
Private Equity is ownership in privately-held companies. Venture capital (VC)
and mergers and acquisitions (M&A) are the two categories of private equity. VC
is the process of investing in a new privately-held company. In this type of
investment, skilled money managers make all the difference. Top-decile managers
know how to pick the winning start-ups, and further have the skill set to make
those start-ups successful. Mergers and Acquisition is the process of purchasing
companies using severe leverage (debt) with the intent to restructure, and
ultimately to resell the company. Here again, the manager’s skills makes the most
difference. Problematic is that the best private equity firms are closed to new
investors (Swensen).
The Bandwagon
When other institutional investors saw Yale’s superior returns, they made the connection
that superior performance could be had by investing in alternatives. Without fully
comprehending the distinctions of alternatives, these institutions rushed into this new
asset class. Unfortunately, these imitators missed the critical variable that determined
Yale’s success: Yale.
Yale’s superior performance is only partially due to its asset allocation. The real
driving factor is superior money manager skill. With billions of dollars under
management, and as a breeding ground for some of the brightest minds, Yale is able
to attract and groom the best money managers in the world. Further, Yale’s success
is also due in part to their very aggressive investment strategy. Being first into the
alternative asset classes, Yale was able to take advantage of the then-inefficient pricing of
alternative assets. A crowded alternative assets market has made more recent superior
risk-adjusted returns harder to come by (Humphreys, Yale Endowment). What was once
an inefficient market has become increasingly efficient – decreasing the opportunity for
excess returns.
The result of smaller institutions jumping on board the alternative bandwagon was
predictable. In the absence of superior manager skill and in the absence of having the
advantage to being first in line, the copycat institutions posted relatively smaller
investment gains. Average active managers dealing in alternative assets in today post
9
The cheapest MLP indexes (ticker MLPA & MLPX) can be had for 45 basis points, or 0.45%.
Not expensive, but not cheap relative to an S&P 500 index fund at just two (2) basis points.
Jon Luskin - MBA Thesis v4.docx Page 16
returns similar to average active managers dealing in conventional assets: less than what
could be had with an index fund (Swensen). If return alone is the goal of the investor,
then the small-time investor is best served by completely avoiding alternative assets.
However, alternative assets offer another value as briefly mentioned above: low
correlation.
Questions to Be Addressed in This Thesis
This paper examines the investment pools of institutions with AUM between $3 and $600
million. These multi-million dollar institutional investors (hereafter MMII) are distinct
from those institutions with investments pools in excess of $1 billion because they do not
have the scale required to retain top-decile money managers. MMII are best served by
utilizing an index fund strategy. This means avoiding alternative assets because
alternatives offer no real index fund (Swensen).
But what about the low correlation offered by alternatives – does the value of low
correlation mean that is there a role for alternative assets in the portfolios of MMII? With
low correlation – but with high fees – can alternative-laden portfolios serve to cushion
MMII from market shocks felt by investors holding only conventional assets?
Consider volatility. Hypothetically, alternative assets could act in a fixed income-like
fashion, keeping the entire portfolio more buoyant against market crisis. Better still, the
higher return potential of alternatives would produce superior returns relative to fixed-
income products. Alternatives, even in the hands of an average money manager may offer
lower returns but superior risk-adjusted performance.
This paper seeks to answer the question: Will a portfolio with allocation to
alternatives between 14% and 38%, without top-decile management, underperform
an index-based portfolio, but still produce superior risk-adjusted returns?
The Most Important Concepts and Their Definitions
The following section explains the investing metrics mentioned in this study. More basic
investing concepts are covered in Appendix C. Readers already familiar with the
concepts of standard deviation, Sharpe Ratio, and Sortino Ratio can skip to Chapter 2:
Overview on page 19.
Standard Deviation is calculated by computing the square root of how far a set of
numbers is spread out (variance). Standard deviation is a function of variability in
returns; it is a measure of volatility or risk. (The terms standard deviation, risk, and
volatility have the same meanings and are referred to interchangeably throughout this
paper.) A higher standard deviation means that fluctuations in investment returns are
more pronounced. Risky assets (like stocks) have higher standard deviations than less-
risky assets (such as bonds). See the following tables Table 1 - Standard deviation
illustration.
The portfolio on the left, with annual returns varying from as high as 10% to as
low as negative 5%, has a standard deviation of 6.2%. The portfolio in the middle, with
returns varying between 1% and 2% per year, has a much lower standard deviation of 0.4
%.
Jon Luskin - MBA Thesis v4.docx Page 17
Risky Portfolio
Safe Portfolio
Bad Portfolio
Year
Return
Value
Return
Value
Return
Value
0
$100.00
$100.00
#$100.00
$100.00
$100.00
$100.00
1
5.00%
$105.00
105.00
2.00%
$102.00
-1.00%
$99.00
2
10.00%
$115.50
115.50
1.00%
$103.02
-1.25%
$97.76
3
-5.00%
$109.73
109.73
1.50%
$104.57
-1.00%
$96.78
Total Return
9.73%
4.57%
-3.22%
Annualized
Return
3.14%
1.50%
-1.08%
Standard
Deviation
6.2%
0.4%
0.1%
Table 1 - Standard deviation illustration
All else being equal, the lower the standard deviation, the better. However, standard
deviation can be a misleading metric because it is a strictly a measure of volatility, not
value. For example, the ‘Bad Portfolio,’ with a negative return, actually has the lowest
standard deviation of all.
Sharpe Ratio is a measure of how well an investor is rewarded for bearing risk. It is a
measure of risk-adjusted performance. The Sharpe Ratio is a mathematical metric that
takes both risk and return into account. As risk goes down, or return goes up, the Sharpe
Ratio increases. Conversely, as risk goes up, or return goes down, the value decreases.
The Sharpe Ratio is calculated as the return (minus the risk-free rate) divided by risk.
10
Risky Investment Portfolio
Safe Investment Portfolio
Year
Return
Investment
Value
Return
Investment Value
0
$100.00
$100.00
1
5%
$105.00
2%
$102.00
2
10%
$115.50
1%
$103.02
3
-5.00%
$109.73
1.50%
$104.57
Total Return
9.73%
4.57%
Annualized Return
3.14%
1.50%
Standard Deviation
0.062
0.004
Sharpe Ratio
0.40
2.50
Table 2 - Sharpe Ratios
In the preceding Table 2 - Sharpe Ratios, the “Risky” portfolio generated annualized
returns in excess of 1.64% per annum over the “Safe” portfolio (3.14% versus 1.50%).
10
See Appendix A: Indexing vs. Active Management
Jon Luskin - MBA Thesis v4.docx Page 18
However, the “Risky” portfolio netted a much lower Sharpe Ratio. Because of the
volatility required to generate those excess returns, the Sharpe Ratio deems the higher-
returning portfolio inferior. The Sharpe Ratio declares that it is not worth the risk
required to generate the higher returns. Higher returns are less valuable in this instance
because there was so much additional risk required to realize those higher returns.
Sortino Ratio is similar to the Sharpe Ratio, but where the Sharpe Ratio gives higher
scores to a portfolio for producing substantially higher returns with slightly higher risk,
the Sortino Ratio gives lower scores to portfolios that fall below a certain performance
threshold. For the case studies to follow, that threshold is set at 5% per annum.
11
Though an arguably aggressive withdrawal rate, certain charitable foundations are
required to spend 5% annually or face tax penalties.
12
Risky Investment Portfolio
Safe Investment Portfolio
Year
Return
Investment
Value
Return
Investment
Value
0
$100.00
$100.00
1
5%
$105.00
2%
$102.00
2
10%
$115.50
1%
$103.02
3
-5.00%
$109.73
1.50%
$104.57
Total Return
9.73%
4.57%
Annualized Return
3.14%
1.50%
Standard Deviation
0.062
0.004
Sharpe Ratio
0.4
2.5
Sortino Ratio
-0.28
-0.99
Why the Sortino Ratio? Non-profit organizations rely on their endowment pool to fund
ongoing operations. If an investment portfolio is unable to consistently produce returns
above a minimum required amount, that investment portfolio is not appropriate. With the
Sortino Ratio, portfolios can be evaluated on their consistency of posting returns above a
required minimum.
Consider the preceding example in Table 3 - Sortino Ratio. Though the Sharpe
Ratio scored the “Safe Investment Portfolio” as more valuable, the Sortino Ratio gives
the “risky” portfolio the higher score. This is because for the Sortino Ratio, a portfolio
that cannot produce returns in excess of 5% annually is not as valuable as one that does,
all else being equal. The higher Sortino Ratio, the better the portfolio.
11
5% is a conventional withdrawal rate for foundations.
12
Endowments are exempt from taxation.
Jon Luskin - MBA Thesis v4.docx Page 19
Chapter 2: Literature Review
Overview
The literature studied includes several topics:
Basic investing principles
Studies of active management efficacy
Indexing investment
History of institutional investing
Endowment model of investing
Non-profit board member fiduciary requirements
Analysis of historical performance of institutional investors: universities,
hospitals and other non-profit organizations
Summary of Major Sources
Pioneering Portfolio Management is the authoritative guide on how to produce an
investment portfolio based on the endowment model.
A Random Walk Down Wall Street examines the efficacy of active management.
The Little Book of Common Sense Investing is an argument for passive management,
made by the pioneer of index funds.
NACUBO-Commonfund Study of Endowments is a statistical report of over 800
endowments across the nation.
Unconventional Success determines inappropriate versus superior investment strategies
for retail investors.
2012: The Yale Endowment is the annual endowment report by Yale’s Chief Investment
Officer, outlining endowment performance and investment strategy.
Once upon a time… is a historical review of investment strategy of nonprofit
organizations.
Educational Endowments and the Financial Crisis examines the weaknesses and social
consequences of the endowment model of investing.
The Curse of the Yale Model compares existing endowment returns relative to the
performance of indexed-based portfolios.
Jon Luskin - MBA Thesis v4.docx Page 20
Assessing Endowment Performance is another index-versus-endowment return
comparison.
For a complete digest of the literature, see Appendix E: Digest of the Literature on page
67.
Methodology
The investigative approach and methods used by the authors in the literature:
Commonfund Institute’s annual publications provide statistical data on
institutional investors’ performance. This data includes statistical breakdown
by such metrics as asset allocation by institution size, return performance by
institution size, and return performance by asset class. There is no
consideration for volatility. Commonfund acquires this information via survey
(Commonfund Institute; National Association of College and University
Business Officers and Commonfund Institute).
The how-to guides, published by investment services companies catering to
non-profit organizations, list fiduciary responsibilities of board members with
respect to an investment pool. These guides explain the evolution of those
fiduciary responsibilities and suggest various investment policy practices to
fulfill those responsibilities. Discussed are investment policy statement
requirements (templates are provided) and portfolio manager selection and
evaluation criteria (Merrill Lynch Center for Philanthropy & Nonprofit
Management; Commonfund; Towers Watson Investment Services; Steele,
Prout and Larson).
Two brief comparisons pit the returns of the average endowment – as
published in the Commonfund study mentioned above – against hypothetical
performance of a portfolio of index funds for the same timetable (Ferri;
Wallick, Wimmer and Schlanger).
The more academic portion of the literature cites studies on the performance
of various investment strategies – sometimes their own – and provides
anecdotes for illustration (Bogle 2007, Bernstein 2010, Swensen 2005,
Malkiel 2012, Stanyer 2010).
Overall Summary and Comparison
What is Known about the Topic
Without retaining top-decile active management, investors are best served by adopting a
portfolio of low-cost, index-based funds, utilizing a buy-and-hold strategy (Bogle;
Bernstein, Malkiel; Stanyer; Swensen).
Jon Luskin - MBA Thesis v4.docx Page 21
Alternative assets require active management (Swensen).
In two brief comparisons, a buy-and-hold, low-cost index-based portfolio outperformed
the returns of the average endowment more often than not (Ferri 2012, Wallick, Wimmer
and Schlanger 2012).
Institutional investors of all sizes suffered a liquidity squeeze during the recent market
downturn, in part because of the illiquid nature of alternative investments (Humphreys
2010, Asch 2010).
Endowments have been consistently increasing their exposure to alternative assets
(Commonfund Institute 2012, National Association of College and University Business
Officers and Commonfund Institute 2012).
What is Unknown
While indexing strategies outperform, there is no analysis of volatility. Does the risk-
adjusted return of actively-managed investments for MMII outperform conventional
assets due to lower volatility?
Major Similarities within the Literature Reviewed
Without retaining top-decile management, a strategy of buy-and-hold index-based
investing is superior.
Differences within the Literature Reviewed
Appropriate asset allocations – and what defines an appropriate asset – are in debate.
Controversies in the Literature
Despite the growing amount of endowment model practitioners, it has its critics. These
critics point to the liquidity squeeze suffered in the midst of the recent sub-prime crisis.
Other critics point to an inappropriate role reversal between the endowment and
university programming; programming being cut for the purposes of preserving the
endowment (Humphreys). Another point of contention is the lack of transparency
inherent in alternative assets (The Responsible Endowment Project 2010, The
Responsible Endowment Project 2009).
Critique
Inconsistencies
Though it is not the subject of this study, authors do not agree on a single investment
strategy; they are not in consensus on the ideal asset allocation nor those asset classes that
are suitable for investment. Regarding the subject of bonds, some of the literature
suggests emerging bonds or corporate bonds as appropriate investments (Stanyer).
Another argument is made for the exclusive holding of long-term Treasuries (Swensen); a
third for the exclusive holding of short-term bonds – with no specification made as to the
bond issuer (Bernstein).
Jon Luskin - MBA Thesis v4.docx Page 22
Strengths
The portion of the literature from the academic community makes a strong case for index
investing in without retaining top-decile managers. This idea is supported by extensive
studies.
Weaknesses
While Ferris and Vanguard’s comparison of investment returns are revealing, they fail to
include a critical variable worthy of examination: volatility. Yes, index investing
outperformed active management. However, what was the volatility of the returns? Is it
superior risk-adjusted performance? Is such volatility appropriate for an endowment?
Those subjects are not discussed. Without that information, it cannot be concluded
whether alternatives are an appropriate investment vehicle for MMII. The specific point
missed is that the value added by alternatives is not necessarily superior returns. It is
diversification and low correlation to conventional asset classes.
Some of the literature reviewed was removed from inclusion because of specious
reasoning. For example, one book cited a separate study as an authoritative source to
prove its argument. The study stated that the inclusion of commodities in an investment
portfolio is a good medium for achieving diversification. That study was funded by a
company in the business of producing commodities, and therefore represents an obvious
conflict of interest.
The less academic portion of the literature suggests a wide range of questionable
investment strategies, including charting (technical analysis or ‘trend following’) and
investing in unproven assets with high management fees (Parness 2002, Richardson and
Faber 2009, Tuttle 2009).
Gaps
The idea of the total value added by alternatives, outside of returns (volatility, risk-
adjusted returns), is not explored.
Limitations
Some of the literature reviewed showed substantial signs of conflicts of interest. The
how-to guides by investment services companies are examples of this.
Point of Departure
This empirical study seeks to address the value added by active management and
alternative assets within the endowment portfolios of eight non-profit investment pools.
Not only will it analyze total return, but also the volatility of annual returns (standard
deviation), considerations for the value of returns relative to risk (Sharpe
13
& Sortino
Ratios), and portfolio performance in times of market crisis.
13
See Appendix A: Indexing vs. Active Management
Jon Luskin - MBA Thesis v4.docx Page 23
Chapter 3: Empirical Study Method
Hypotheses
This study seeks to test the following hypothesis:
Investment pools will underperform index-based portfolios (in part because of the
effect of fees), but will experience less volatility and superior returns in times of
market crisis (because of the diversification value of alternative asset allocation).
Said another way, alternative-laden portfolios will forfeit higher returns in exchange for
less volatility when compared to portfolios without alternative asset allocation.
Specifically, alternative-laden portfolios will outperform conventional portfolios in years
of market crisis. For the purposes of this study, market crisis is defined as the bursting of
the internet bubble (Fiscal Year (FY) 2001-3); the sub-prime crisis (FY 2008-9); and the
more recent poor performance of international and small domestic companies (FY
2012).
14
These periods of poor market performance are referred hereafter to as ‘bad
years.’
What follows is the description of a simple index-based portfolio. The
performance of this comparison portfolio will be used to evaluate the following case
studies. Also, included as points of reference is the conventional 60/40 benchmark as
well as the S&P 500.
15
For more about these benchmarks, see Appendix D: 60/40
Benchmark on page 63 and Appendix A: Indexing vs. Active Management on page 58,
for the 60/40 and S&P 500 respectively.
Swensen Portfolio
David Swensen, Chief Investment Officer at Yale and pioneer of the “Endowment
Model,” suggests a boiler-plate portfolio for those that do not have the resources to retain
top-decile active management. This suggestion applies to retail investors and MMII alike.
This low-cost index fund model specifies diversification across six distinct asset classes:
15% long-term Treasuries, 15% inflation-protected Treasuries, 20% Real Estate
Investment Trust (REIT) index, 5% emerging markets index, 15% foreign developed
markets index, and 30% US stock market index. See the following Table 4 - Asset Class
Allocations of Swensen Portfolios.
14
Endowments are reporting that “International equities and real assets were affected by the
debt and sovereign crisis in the Eurozone as well as slowing growth in China and other emerging
markets” (Wo, University of Hawaii Foundation 2012 Endowment Report).
15
Performance all benchmarks were calculated using DFA Returns 2.0.
Jon Luskin - MBA Thesis v4.docx Page 24
Asset Class Allocations – Swensen Portfolios
Asset Class
Index
Swensen
Swensen
65/30/5
US Broad Market
Dow Jones US Total Stock Market Index
30%
25%
US REIT
S&P United States REIT Index (gross dividends)
20%
20%
International
MSCI EAFE Index (gross dividends)
15%
15%
Emerging
MSCI Emerging Markets Index (gross dividends)
5%
5%
Treasuries
Barclays Treasury Bond Index Long
15%
15%
TIPS
Barclays US TIPS Index
15%
15%
Cash Equivalent
BofA Merrill Lynch 3-Month US Treasury Bill Index
0%
5%
Table 4 - Asset Class Allocations of Swensen Portfolios
In order to provide a relevant benchmark, the Swensen portfolio is modified to meet the
liquidity requirements of foundations making regular fund distributions. The rightmost
column in Table 4 - Asset Class Allocations of Swensen Portfolios, “Swenson 65/30/5”
allocates five percent to a cash equivalent. In addition to providing further liquidity, this
modification serves a second function: decreasing the volatility inherent in this portfolio.
Not only is the largest asset class (domestic broad market) reduced by 5%, but it is
replaced by a 5% cash equivalent that adds further stability. Moving forward, any
reference to the “Swensen portfolio” shall refer to the modified “Swensen 65/30/5”
discussed above. This portfolio is rebalanced annually.
Background of the Data Source
Case studies are non-profit organizations with AUM under $1 billion, which provided
data (either publicly or privately) on annual investment returns in excess of nine years.
Public data is sourced from annual endowment reports as posted on foundation websites.
Private data has been supplied directly to the author from participating institutions.
Procedure Used to Collect Data
Case studies were acquired via endowment publications, and by contacting organizations
individually for investment return data.
Advantages and Disadvantages of this Method
Selection Bias
While online research makes for expedient gathering of data, one problem with this
method is selection bias; the only information available is that which an organization
chooses to make public. This may exclude poorer performing investment portfolios for
the reason that the parties responsible do not wish to make their fund’s performance
public knowledge. While over 100 California-based non-profits were asked to participate
in this study, only one agreed – and only on the condition of anonymity.
Jon Luskin - MBA Thesis v4.docx Page 25
The Bond Bubble
The time period evaluated is a unique one: two severe market downturns concurrent with
a rising bond bubble. With bond prices set to plummet at the culmination of the Federal
Reserve’s quantitative easing, the future for heavily bond-laden portfolios is bleak.
16
For
the period reviewed, the 60/40 portfolio exhibited strong performance, in part, because of
rising bond prices. How these portfolios perform in the future – amidst increasing interest
rates – will be entirely different.
Infrequent Data
There was only consideration of annual performance. Monthly or quarterly return data
was not available. Such infrequent measurements likely understate the true volatility of
the endowment portfolios under examination.
16
Bonds prices have an inverse relationship to interest rates. When interest rates are low, bonds
prices are high. With current interest rates at their lowest ever, bond prices are at their highest
ever. Any reversion of interest rates to historic averages (read: increase in interest rates) will
proportionally decrease the value of any bond.
Jon Luskin - MBA Thesis v4.docx Page 26
Chapter 4: Findings
Jon Luskin - MBA Thesis v4.docx Page 27
California Social Services Organization
California Social Services Organization
17
(hereafter CSSO), has $3.5 million AUM.
Without the resources available by having a large investment pool, CSSO is best served
by a strategy of buy-and-hold, utilizing low-cost index funds (Swensen 2009, Stanyer
2010). This, however, is the not the technique used by CSSO’s outsourced portfolio
manager. In fact, CSSO’s portfolio manager utilizes a doubly-opposite technique:
frequent trading of actively-managed mutual funds.
18
Figure 3 - California Social Services Organization asset allocation
Such a method of active trading, or market timing, is exactly what the literature review
advises against (Swensen, Malkiel 2012). Not only do actively managed mutual funds
usually fail to match market returns, but frequency of trading is inversely proportional to
the growth of wealth (Bogle 2007, Barber and Odean 2000). While such a trading
technique can be profitable, CSSO’s portfolio’s trade history shows multiple losses when
selling mutual funds for less than their initial purchase price. Such losses occurred on
numerous occasions. Ultimately, these losses were offset by gains, giving CSSO an
annualized return of 7.90% before fees. Based on the limited availability of data, CSSO’s
17
CSSO is not the real name of the organization. CSSO provided data for this project on the
condition of anonymity.
18
Such a mode would indeed be unbelievable, if not for the 10-year history of buy and sell
transactions made available by CSSO to the author.
Large Value
6%
Large Blend
6%
Large Growth
7%
Mid-Cap Growth
2%
Mid-Cap Value
2%
Small Growth
2%
Small Blend
2%
Foreign Large
Blend
6%
Foreign Small/Mid
Blend
3%
Diversified
Emerging Mkts
1%
Diversified
Emerging Mkts
Small Cap
2%
"Conservative
Hedge Fund"
10%
"Tactical Strategy"
8%
"Absolute Return"
6%
"Energy
Infrastructure"
6%
Multisector Bond
4%
Intermediate-Term
Bond
15%
3 month T-bill
13%
Jon Luskin - MBA Thesis v4.docx Page 28
portfolio return net of fees is estimated to be 7.50% per annum.
19
See Table 5 - CSSO 10
Calendar Year Returns, Ending December 31st, 2012 for results.
CSSO 10 Calendar Year Returns, Ending December 31
st
, 2012
Index
Annualized
Total
STD
Dev.
Sharpe
Ratio
Sortino
Ratio
CSSO - gross of fees actual
7.90%
113.90%
18.05%
0.38
0.36
CSSO - net of fees, estimate
7.50%
106.15%
17.37%
0.4
0.32
S & P 500
7.10%
98.59%
18.32%
0.37
0.29
60/40
6.77%
92.46%
9.63%
0.53
0.31
Swensen - 65/30/5
9.78%
154.32%
13.41%
0.63
0.64
Swensen Portfolio
The index-based Swensen 65/30/5 generated a ten-year annualized return of 9.78%. The
Swensen model offers less risk (smaller standard deviation) as well. ‘Bad year’
performance was also superior: the Swensen model suffered a loss of -22.76% in 2009.
This is relative to CSSO’s 2009 performance of -33%. Further, in 2011, while CSSO was
generating negative returns, the Swensen portfolio posted a positive return of 5.7%.
19
See Appendix F: CSSO Net of Fees Estimate on page 118 for calculations.
Table 5 - CSSO 10 Calendar Year Returns, Ending December 31st, 2012
CSSO Calendar Year 2009 & 2011 Performance
Portfolio / Index
2009
2011
CSSO, gross of fees actual
-33.31%
-2.32%
CSSO, net of fees estimate
-33.68%
-2.67%
S&P 500
-37.00%
2.11%
60/40
-17.24%
4.88%
Swensen 65/30/5
-22.76%
5.70%
Table 6 - CSSO Calendar Year 2009 & 2011 Performance
Jon Luskin - MBA Thesis v4.docx Page 29
Figure 4 – California Social Services Organization & comparison portfolio growth
Conclusion
The hypothesis states that actively managed portfolios, with their alternative assets, will
underperform benchmarks but will experience less risk. For CSSO’s portfolio just
reviewed, this was not the case. Instead of giving up higher returns in exchange for lower
volatility, CSSO’s outsourced portfolio manager generated lower returns with more
volatility. The hypothesis is rejected. Thus, CSSO’s portfolio manager provided less
value than the Swensen 65/30/5.
The following Table 7 - CSSO Portfolio Performance Relative Benchmarks
illustrates how the CSSO portfolio compares to benchmarks. A red cell indicates. A green
value represents outperformance. Against the Swensen portfolio, the CSSO portfolio
shows no instances of outperformance given the metrics under consideration.
CSSO Portfolio Performance Relative Benchmarks
Portfolio / Index
Annualized
Return
STD
Dev.
Sharpe
Ratio
Sortino
Ratio
2009
Return
2011
Return
S & P 500
0.40%
-0.27%
0.01
0.03
3.32%
-4.78%
60/40
0.73%
8.42%
-0.15
0.01
-16.44%
-7.55%
Swensen - 65/30/5
-2.28%
4.64%
-0.25
-0.32
-10.92%
-8.37%
Key
CSSO Superior Performance
CSSO Inferior Performance
Table 7 - CSSO Portfolio Performance Relative Benchmarks
Conflicts of Interest
Due to conflicts of interest, the manager was incentivized to over-trade holdings.
Therefore, the ability to accurately assess the value of alternative assets is compromised.
To learn about the conflicts of interest that manifest themselves in CSSO’s portfolio, see
Appendix G: CSSO’s Problematic Portfolio on page 101.
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
2.60
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Wealth Growfth Factor
CSSO, net of fees estimate
S&P 500
60/40
Swensen - 60/30/5
Jon Luskin - MBA Thesis v4.docx Page 30
University of Hawaii Foundation
Suffering from negative returns in FY
20
2012, University of Hawaii Foundation (UHF)
stewards $201.5 million in AUM. Holding a mere 14 funds in 2004, this number more
than tripled to 50 funds by 2011. Only six of the original 14 remained in the portfolio by
the end of FY 2011.
21
Like California Social Services Organization (CSSO), UHF’s
portfolio manager trades holdings frequently. The average holding period for an
investment is just under three and a half years
22
(Wo n.d.).
Figure 5 - University of Hawaii Foundation asset allocation
Swensen Portfolio
Relative to UHF’s portfolio, the Swensen portfolio produced exceptionally higher
returns, though with higher volatility (risk). See Table 8 - Performance Metrics of Nine
Consecutive FYs, ending June 30th, 2012 for the entirety of metrics. This excessive risk
is reflected in a greater loss than what UHF’s portfolio endured in 2008 and 2009. See
Table 9 - UHF FY 2008, 2009 & 2012 Performance Relative Indices. Ultimately, for the
time period evaluated (July 1
st
, 2003 to June 30
th
, 2012), the Swensen portfolio produced
superior returns for the volatility – as judged by the Sharpe and Sortino Ratios.
20
Academic fiscal years run from July 1
st
to June 30
th
of the following year. For example, fiscal
year 2012, (FY2012), runs from July 1
st
2011 through June 30
th
, 2012.
21
One fund, State Street Global Advisors S&P 500 Index, underperformed a comparable
Vanguard Index by the exact difference of their expense ratio.
22
As calculated by computing the average years a fund is held, over the 8 years that the holdings
were documented in UHF’s annual endowment reports.
US Equity
19%
International
Developed
16%
Emerging
8%
Fixed Income
13%
Cash Equivelants
4%
Marketable
Alternative Assets
19%
Private
Equity/Venture
Capital
6%
Inflation Hedge
Assets
15%
Jon Luskin - MBA Thesis v4.docx Page 31
Performance Metrics of Nine Consecutive FYs, ending June 30th, 2012
Portfolio
Annualized
Returns
Total
Return
STD
Dev.
Sharpe Ratio
Sortino
Ratio
UHF actual
6.37%
74.30%
11.7%
0.414
0.248
S&P 500
5.91%
67.71%
17.5%
0.290
0.193
60/40
5.88%
67.28%
9.8%
0.406
0.194
Swensen 65/30/5
8.86%
114.63%
13.6%
0.540
0.531
Table 8 - Performance Metrics of Nine Consecutive FYs, ending June 30th, 2012
UHF FY 2008, 2009 & 2012 Performance Relative Indices
Portfolio / Index
FY 2008
FY 2009
FY 2012
UHF actual
-1.7%
-16.8%
-2.1%
S&P 500
-13.12%
-26.22%
5.45%
60/40
-4.00%
-13.08%
6.60%
Swensen 65/30/5
-2.93%
-20.37%
7.34%
Figure 6 - University of Hawaii Foundation & comparison portfolio growth
Conclusion
In the case of UHF and the data analyzed thus far, it would appear that active
management and the accompanying alternative assets are effectively minimizing
portfolio losses in certain instances – buffering the portfolio from the sub-prime
crisis. UHF’s active management and alternative asset allocation thus acted as a slight
hedge against sharp market downward movements, making the portfolio more buoyant
than the comparison portfolio.
23
23
More risk for more return – this is a tenet of modern portfolio theory as discussed in the
literature review. The ability to buffer against the sub-prime crisis has come at the expense of
1.03
1.23
1.43
1.63
1.83
2.03
2004 2005 2006 2007 2008 2009 2010 2011 2012
Growth of Wealth Factor
UHF Actual
S&P 500
60/40
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 32
For all its active management and alternative assets, UHF’s portfolio manager has
sometimes managed to reduce negative returns amidst markets shocks. UHF’s portfolio
outperformed in FY 2008 and 2009, but produced exceptionally poor performance in FY
2012. FY 2012 performance is the basis for the hypothesis’s rejection.
UHF Portfolio Performance Discrepancies Relative Index-Based Portfolios
Portfolio / Index
Return
STD
Sharpe
Sortino
FY 2008
FY 2009
FY 2012
S & P 500
0.46%
-5.80%
0.12
0.06
11.42%
9.42%
-7.55%
60/40
0.49%
1.90%
0.01
0.05
2.30%
-3.72%
-8.70%
Swensen
-2.49%
-1.90%
-0.13
-0.28
1.23%
3.57%
-9.44%
Key
UHF Superior Performance
UHF Inferior Performance
Table 10 - UHF Portfolio Performance Discrepancies Relative Index-Based Portfolios
returns. The same benefit, it be argued, could be had with a less aggressive equity allocation. This
idea – that an index-based portfolio with a greater allocation than 30% to fixed income could
outperform UHF’s portfolio – is discussed in the conclusion. Those readers eager to see the
results may skip to University of Hawaii Foundation on page 51.
Jon Luskin - MBA Thesis v4.docx Page 33
Washington State University Foundation’s Endowment Fund
Washington State University Foundation’s Endowment Fund (WSUFEF) holds $318.1
million as of June 30, 2012.
Figure 7 - Washington State University Foundation’s Endowment Fund asset allocation
It posted a 6.16% per annum return over the last 10 FYs. WSUFEF’s performance in
times of market crisis was mixed. For FY 2008, when the first effects of the sub-prime
crisis were being felt, WSUFEF pushed out a small positive return of 1.6%. This is in
contrast to the S&P, which fell in excess of 13%. However in 2009, WSUFEF fell
dramatically with the market.
Performance for 10 FY Returns, ending June 30th, 2012
Portfolio / Index
Annualized
Returns
Total Return
STD Dev.
Sharpe
Ratio
Sortino
Ratio
WSUFEF actual
6.16%
130.77%
12.16%
0.40
0.217
S&P 500
5.33%
106.98%
16.68%
0.27
0.140
60/40
5.76%
119.11%
9.25%
0.42
0.179
Swensen 65/30/5
8.56%
215.62%
12.87%
0.55
0.514
Table 11 - Performance for 10 FY Returns, ending June 30th, 2012
WSUFEF FY 2003, 2008, 2009 & 2012 Performance
Portfolio / Index
FY 2003
FY 2008
FY 2009
FY 2012
WSUFEF actual
2.63%
1.60%
-21.10%
0.00%
S&P 500
0.26%
-13.12%
-26.22%
5.45%
60/40
4.68%
-4.00%
-13.08%
6.60%
Swensen 65/30/5
5.89%
-2.93%
-20.37%
7.34%
Table 12 - FY 2003, 2008, 2009 & 2012 Performance
Figure 8 - Washington State University Foundation’s Endowment Fund & comparison
portfolio growth shows the value added by active management and alternative asset
allocation: greater stability in returns. Again, active management and alternative assets
are behaving like fixed-income: stifling returns in exchange for safety of principal.
U.S. Equity
14%
Non-U.S. Equity
17%
U.S. Fixed Income &
Cash
13%
Absolute Return
20%
Real Estate
15%
Private Equity
21%
Jon Luskin - MBA Thesis v4.docx Page 34
Figure 8 - Washington State University Foundation’s Endowment Fund & comparison portfolio growth
Swensen Portfolio
The Swensen portfolio grossly outperformed the WSUFEF portfolio in excess of 2% per
annum. The trade-off, as seen in the previous case study, was an increase in volatility,
albeit a small one (less than one percent of standard deviation). The Sharpe and Sortino
Ratios, laid out in Table 11 - Performance for 10 FY Returns, ending June 30th, 2012
manifest the value added of the Swensen model over WSUFEF via higher scorings.
Further, the Swensen model outperformed in three out of four ‘bad years.’
Conclusion
The verdict of WSUFEF is similar to University of Hawaii Foundation (UHF). While
WSUFEF’s portfolio forfeited performance to gain safety, ultimately poor FY 2012
performance precluded the acceptance of the hypothesis. Actively managed alternative
assets undoubtedly added value, functioning to buffer WSUFEF’s portfolio, most
substantially at the start of the financial crisis (FY 2008). However, in exchange for
slightly less volatility and a better 2008 return, the WSUFEF portfolio gives up every
other metric to Swensen, including returns in excess of 2% per annum over 10 years.
WSUFEF Portfolio Performance Discrepancies
Portfolio / Index
Return
STD
Sharpe
Sortino
FY
2003
FY
2008
FY
2009
FY
2012
S & P 500
0.82%
-4.52%
0.13
0.08
2.37%
14.72%
5.12%
-5.45%
60/40
0.39%
2.91%
-0.02
0.04
-2.05%
5.60%
-8.02%
-6.60%
Swensen 65/30/5
-2.40%
-0.71%
-0.15
-0.30
-3.26%
4.53%
-0.73%
-7.34%
Key
WSUFEF Superior Performance
WSUFEF Inferior Performance
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Wealth Growth Factor
WSUF
S&P 500
60/40
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 35
University of Northern Carolina, Wilmington
At the conclusion of FY 2012, the University of Northern Carolina, Wilmington
(UNCW) had nearly $68 million AUM. The university privately provided 11 years of
investment return data for this study.
Figure 9 - University of Northern Carolina, Wilmington asset allocation
Swensen Portfolio
The Swensen portfolio again outperforms the case study portfolio UNCW, posting
returns in excess of one percent per annum. This gain in returns is offset by additional
volatility. Like UHF, UNCW’s portfolio exhibited superior sub-prime crisis performance
(FY 2008 & 2009).
UNCW Performance of 11 Consecutive FYs, ending June 30th, 2012
Portfolio / Index
Annualized
Returns
Total
Return
STD Dev.
Sharpe
Ratio
Sortino
Ratio
UNCW actual
6.77%
105.54%
10.72%
0.49
0.33
S&P 500
2.96%
37.89%
17.48%
0.13
-0.05
60/40
4.51%
62.39%
9.66%
0.28
-0.01
Swensen 65/30/5
7.81%
128.79%
12.49%
0.50
0.44
Table 14 - UNCW Performance of 11 Consecutive FYs, ending June 30th, 2012
U.S. Equity
24%
Non-U.S. Equity
10%
Global Equity
17%
U.S. Fixed Income
32%
Energy & Natural
Resources
4%
Real Estate
1%
Private Equity
9%
Commodities
1%
UNCW FY 2002, 2003, 2008, 2009 & 2012 Performance
Portfolio / Index
FY 2002
FY 2003
FY 2008
FY 2009
FY 2012
UNCW actual
-6.93%
1.90%
4.99%
-14.48%
5.70%
S&P 500
-17.99%
0.26%
-13.12%
-26.22%
5.45%
60/40
-7.27%
4.68%
-4.00%
-13.08%
6.60%
Swensen 65/30/5
0.67%
5.89%
-2.93%
-20.37%
7.34%
Table 15 - - UNCW FY 2002, 2003, 2008, 2009 & 2012 Performance
Jon Luskin - MBA Thesis v4.docx Page 36
For the risk endured, the Swensen model outperformed, posting superior risk-adjusted
returns. While the difference in Sharpe Ratio was negligible, the difference in Sortino
Ratios was notable. (See Table 14 - UNCW Performance of 11 Consecutive FYs, ending
June 30th, 2012.) And while the UNCW portfolio proved more resilient to the recent
subprime crisis (FY 2008 & 2009) than the Swensen model, the Swensen model posted
better returns in the wake of tech bubble (FY 2002 & 2003).
Figure 10 – University of Northern Carolina, Wilmington & comparison portfolio growth
Conclusion
The hypothesis is again rejected. While the UNCW portfolio did underperform the
Swensen model with less risk, it did not post superior performance in every instance of
the ‘bad years.’ See the following Table 16 - UNCW Portfolio Performance
Discrepancies.
Table 16 - UNCW Portfolio Performance Discrepancies
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Wealth Growth Factor
UNCW
S&P 500
60/40
Swensen 65/30/5
UNCW Portfolio Performance Discrepancies
Index
Return
STD
Dev.
Sharpe
Sortino
FY
2002
FY
2003
FY
2008
FY
2009
FY
2012
S & P 500
3.81%
-6.76%
0.36
0.38
11.06%
1.64%
18.11%
11.74%
0.25%
60/40
2.26%
1.06%
0.21
0.34
0.34%
-2.78%
8.99%
-1.40%
-0.90%
Swensen
-1.04%
-1.77%
-0.01
-0.11
-7.60%
-3.99%
7.92%
5.89%
-1.64%
Key
UNCW Superior Performance
UNCW Inferior Performance
Jon Luskin - MBA Thesis v4.docx Page 37
University of California, Santa Barbara Foundation
University of California, Santa Barbara Foundation (UCSBF), reported $206,033,000
AUM at the end of FY 2012.
Figure 11 - University of California, Santa Barbara Foundation asset allocation
Among its fellow UC foundations, UCSBF posted the worst returns for the 14 year
period evaluated: 4.22% per annum. UCSBF’s performance is reflected in a negative
Sortino Ratio. It is the only portfolio to generate a negative Sortino Ratio in this study.
UCSBF Fourteen FY Returns, ending June 30th, 2012
Portfolio / Index
Annualized
Returns
Total
Return
STD Dev.
Sharpe
Ratio
Sortino
Ratio
UCSBF actual
4.22%
78.42%
12.64%
0.17
-0.003
S&P 500
3.16%
54.62%
17.03%
0.10
-0.038
60/40
4.65%
88.92%
9.32%
0.23
0.007
Swensen - 65/30/5
7.28%
167.52%
11.16%
0.43
0.393
Table 17 - UCSBF Fourteen FY Returns, ending June 30th, 2012
UCSBF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
Portfolio / Index
FY 2001
FY 2002
FY 2003
FY 2008
FY 2009
FY
2012
UCSBF actual
-6.70%
-9.40%
5.60%
-9.40%
-20.70%
-3.40%
S&P 500
-14.83%
-17.99%
0.26%
-13.12%
-26.22%
5.45%
60/40
-4.76%
-7.27%
4.68%
-4.00%
-13.08%
6.60%
Swensen - 65/30/5
0.52%
0.67%
5.89%
-2.93%
-20.37%
7.34%
Table 18 - UCSBF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
U.S. Equity
24%
Non-U.S. Equity
20%
U.S. Fixed Income
21%
Non-U.S. Fixed
Income
1%
Absolute Return
23%
Real Estate
4%
Private Equity
7%
Commodities
2%
Cash Equiv
1%
Jon Luskin - MBA Thesis v4.docx Page 38
Swensen Portfolio
For the time period measured, the Swensen portfolio outperformed, posting annual
returns in excess of three percentage points per annum over UCSBF’s return.
24
Consider
that UCSBF This outperformance occurred while enduring less risk as well. Further, the
Swensen portfolio showed smaller losses in all six ‘bad’ years reviewed, including a
return in excess of 7% percent in FY 2012.
Figure 12 - University of California, Santa Barbara Foundation & comparison portfolio growth
Conclusion
The hypothesis is rejected. In this instance, it is clear that active management, with its
accompanying alternative asset allocation, has failed to provide value. To the
contrary, the strategy has subtracted value. Had UCSBF utilized the Swensen portfolio,
its holdings would be estimated at $308 million, over $100 more than its current value.
UCSBF Portfolio Performance Relative Benchmarks
Index
Return
STD
Dev.
Sharpe
Sortino
FY
2001
FY
2002
FY
2003
FY
2008
FY
2009
FY
2012
S & P
1.06%
-4.39%
0.07
0.04
8.13%
8.59%
5.34%
3.72%
5.52%
-8.85%
60/40
-0.43%
3.32%
-0.06
-0.01
-1.94%
-2.13%
0.92%
-5.40%
-7.62%
-10.00%
Swensen
-3.06%
1.48%
-0.26
-0.40
-7.22%
-10.07%
-0.29%
-6.47%
-0.33%
-10.74%
Key
UCSBF Superior
Performance
UCSBF Inferior
Performance
Table 19 - UCSBF Portfolio Performance Relative Benchmarks
24
0.9
1.1
1.3
1.5
1.7
1.9
2.1
2.3
2.5
2.7
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Wealth Growth Multiple
UCSBF
S&P 500
60/40
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 39
University of California, Irvine Foundation
University of California, Irvine Foundation held $293,180,000 AUM at the close of FY
2012.
Figure 13 - University of California, Irvine Foundation asset allocation
25
University of California, Irvine Foundation (UCIF) produced annualized returns of
4.83%.
UCIF Performance of 14 Consecutive FYs, ending June 30th, 2012
Portfolio / Index
Annualize
d Returns
Total
Return
STD
Dev.
Sharpe
Ratio
Sortino
Ratio
UCIF actual
4.83%
93.47%
11.08%
0.23
0.049
S&P 500
3.16%
54.62%
17.03%
0.10
-0.038
60/40
4.65%
88.92%
9.32%
0.23
0.007
Swensen 65/30/5
7.28%
167.52%
11.16%
0.43
0.393
Table 20 - UCIF Performance of 14 Consecutive FYs, ending June 30th, 2012
UCIF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
Portfolio / Index
FY 2001
FY 2002
FY 2003
FY 2008
FY 2009
FY
2012
UCIF actual
-3.40%
-7.20%
6.50%
-2.90%
-20.60%
0.40%
S&P 500
-14.83%
-17.99%
0.26%
-13.12%
-26.22%
5.45%
60/40
-4.76%
-7.27%
4.68%
-4.00%
-13.08%
6.60%
Swensen 65/30/5
0.52%
0.67%
5.89%
-2.93%
-20.37%
7.34%
Table 21 - UCIF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
25
Not pictured is 0.1% cash equivalent.
U.S. Equity
24%
Non-U.S. Equity
15%
Global Equity
1%
U.S. Fixed
Income
13%
Non-U.S. Fixed
Income
3%
Absolute Return
23%
Real Estate
6%
Private Equity
12%
Commodities
3%
Jon Luskin - MBA Thesis v4.docx Page 40
Swensen Portfolio
Against the Swensen portfolio, UCIF’s actual portfolio provides little advantage. With a
negligibly larger standard deviation, the Swensen portfolio generates returns of 2.45%
per annum, and produced superior performance in four of the six ‘bad years.’
Figure 14 – University of California, Irvine Foundation & comparison portfolio growth
Conclusion
The hypothesis is rejected. While there were instances where UCIF provided lower
returns in exchange for less risk, the UCIF portfolio was not able to produce superior
returns in all of the ‘bad’ years considered; the UCIF portfolio did not consistently buffer
UCIF’s investments against market shocks. Further, the difference in risk is negligible at
eight basis points (0.08%) of standard deviation.
UCIF Performance Relative Benchmarks
Index
Return
STD
Sharpe
Sortino
FY
2001
FY
2002
FY
2003
FY
2008
FY
2009
FY
2012
S & P
1.67%
-5.95%
0.13
0.09
11.43%
10.79%
6.24%
10.22%
5.62%
-5.05%
60/40
0.18%
1.76%
0.00
0.04
1.36%
0.07%
1.82%
1.10%
-7.52%
-6.20%
Swensen
-2.45%
-0.08%
-0.20
-0.34
-3.92%
-7.87%
0.61%
0.03%
-0.23%
-6.94%
Key
UCIF Superior
Performance
UCIF Inferior Performance
Table 22 - UCIF Performance Relative Benchmarks
0.9
1.1
1.3
1.5
1.7
1.9
2.1
2.3
2.5
2.7
Wealth Growth Factor
UCIF
60/40
S&P 500
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 41
University of California, Riverside Foundation
University of California, Riverside Foundation held AUM of $138,816,000 at FY 2012
end.
Figure 15 University of California, Riverside Foundation asset allocation
26
UCRF posted returns of 6.68% per annum.
UCRF Performance of 14 Consecutive FYs, ending June 30th, 2012
Portfolio/Index
Annualized
Returns
Total
Return
STD Dev.
Sharpe Ratio
Sortino
Ratio
UCRF actual
6.68%
147.16%
11.95%
0.38
0.293
S&P 500
3.16%
54.62%
17.03%
0.10
-0.038
60/40
4.65%
88.92%
9.32%
0.23
0.007
Swensen
7.28%
167.52%
11.16%
0.43
0.393
Table 23 - UCRF Performance of 14 Consecutive FYs, ending June 30th, 2012
UCRF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
Portfolio/Index
FY 2001
FY 2002
FY 2003
FY 2008
FY 2009
FY 2012
UCRF actual
0.50%
-4.10%
4.10%
2.80%
-22.10%
-2.60%
S&P 500
-14.83%
-17.99%
0.26%
-13.12%
-26.22%
5.45%
60/40
-4.76%
-7.27%
4.68%
-4.00%
-13.08%
6.60%
Swensen 65/30/5
0.52%
0.67%
5.89%
-2.93%
-20.37%
7.34%
Table 24 - UCRF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
Swensen Portfolio
UCRF still failed to outperform the Swensen model by almost every metric considered.
When comparing UCRF’s performance against the Swensen portfolio, the Swensen
model outperforms by less than one percent per annum. Higher returns coupled with less
volatility gives the Swensen portfolio higher Sharpe and Sortino Ratios. In four out of six
26
Not pictured is 0.1% cash equivalent.
U.S. Equity
24%
Non-U.S. Equity
15%
Global Equity
1%
U.S. Fixed Income
13%
Non-U.S. Fixed
Income
3%
Absolute Return
23%
Real Estate
6%
Private Equity
12%
Commodities
3%
Jon Luskin - MBA Thesis v4.docx Page 42
instances, the Swensen portfolio exhibited superior ‘bad year’ performance. (In FY2001,
the two portfolios posted similar returns.) FY 2008 performance is the exception.
Figure 16 – University of California, Riverside Foundation & comparison portfolio growth
Conclusion
The hypothesis is rejected. The numbers show UCRF’s failure to provide any consistent
value over the Swensen model. The differences are laid out in Table 25 - UCRF Portfolio
Performance Relative Benchmarks.
UCRF Portfolio Performance Relative Benchmarks
Index
Return
STD
Sharpe
Sortino
FY
2001
FY
2002
FY
2003
FY
2008
FY
2009
FY
2012
S & P 500
3.51%
-5.08%
0.28
0.33
15.33%
13.89%
3.84%
15.92%
4.12%
-8.05%
60/40
2.03%
2.63%
0.15
0.29
5.26%
3.17%
-0.58%
6.80%
-9.02%
-9.20%
Swensen
-0.60%
0.79%
-0.05
-0.10
-0.02%
-4.77%
-1.79%
5.73%
-1.73%
-9.94%
Key
UCRF Superior
Performance
UCRF Inferior
Performance
0.90
1.10
1.30
1.50
1.70
1.90
2.10
2.30
2.50
2.70
1999 20002001 20022003 20042005 20062007 2008 20092010 20112012
Wealth Growth Factor
UCRF
S&P 500
60/40
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 43
University of California, San Francisco Foundation
Among this paper’s case studies, University of California, San Francisco Foundation
holds the greatest amount of assets under management: $675 million.
Figure 17 - University of California, San Francisco Foundation Asset Allocation
27
UCSFF set an annualized return of nearly six percent per year. Part of UCSFF’s success
is from an extremely high return in FY 2000: 23.9%.
UCSFF Performance of 14 Consecutive FYs, ending June 30th, 2012
Portfolio/Index
Annualized
Returns
Total
Return
STD
Dev.
Sharpe Ratio
Sortino
Ratio
UCSFF actual
5.95%
124.62%
11.98%
0.32
0.205
S&P 500
3.16%
54.62%
17.03%
0.10
-0.038
60/40
4.65%
88.92%
9.32%
0.23
0.007
Swensen
7.28%
167.52%
11.16%
0.43
0.393
Table 26 - UCSFF Performance of 14 Consecutive FYs, ending June 30th, 2012
USSFF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
Portfolio/Index
FY 2001
FY 2002
FY 2003
FY 2008
FY 2009
FY
2012
UCSFF actual
-1.50%
-6.80%
0.90%
-7.50%
-16.50%
-0.90%
S&P 500
-14.83%
-17.99%
0.26%
-13.12%
-26.22%
5.45%
60/40
-4.76%
-7.27%
4.68%
-4.00%
-13.08%
6.60%
Swensen 65/30/5
0.52%
0.67%
5.89%
-2.93%
-20.37%
7.34%
Table 27 - USSFF FY 2001, 2002, 2003, 2008, 2009 & 2012 Performance
27
Not pictured is 0.1% cash equivalent.
U.S. Equity
20%
Non-U.S. Equity
19%
U.S. Fixed Income
14%
Non-U.S. Fixed
Income
6%
Absolute Return
23%
Real Estate
2%
Private Equity
6%
Commodities
5%
Cash Equiv
5%
Jon Luskin - MBA Thesis v4.docx Page 44
Swensen
UCSFF’s portfolio did not outperform the Swensen model. Further, UCSFF’s
underperformance was not with less risk. On the contrary, it came with more risk. When
back-to-back with the Swensen model, it was another instance of more risk for less
return. UCSFF’s portfolio failed in every metric, save superior performance in FY 2008.
During this period, USCFF bested the Swensen model by a significant 5%. All other
metrics go to Swensen.
Figure 18 – University of California, San Francisco Foundation & comparison portfolio growth
Conclusion
The hypothesis is rejected. The following Table 28 - UCSFF Performance Relative
Benchmarks illuminates the inferiority of UCSFF’s portfolio relative to the Swensen
portfolio. Like with UCRF, the UCSFF portfolio showed a significant advantage over the
Swensen model in only one metric: performance in FY 2009.
UCSFF Performance Relative Benchmarks
Index
Return
STD
Sharpe
Sortino
FY 2001
FY 2002
FY
2003
FY
2008
FY
2009
FY
2012
S&P 500
2.79%
-5.05%
0.22
0.24
13.33%
11.19%
0.64%
5.62%
9.72%
-6.35%
60/40
1.30%
2.66%
0.09
0.20
3.26%
0.47%
-3.78%
-3.50%
-3.42%
-7.50%
Swensen
-1.33%
0.82%
-0.11
-0.19
-2.02%
-7.47%
-4.99%
-4.57%
3.87%
-8.24%
Key
UCSFF Superior Performance
UCSFF Inferior Performance
Table 28 - UCSFF Performance Relative Benchmarks
0.90
1.10
1.30
1.50
1.70
1.90
2.10
2.30
2.50
2.70
19992000200120022003200420052006200720082009201020112012
Wealth Growth Factor
UCSFF
S&P 500
60/40
Swensen 65/30/5
Jon Luskin - MBA Thesis v4.docx Page 45
Chapter 5: Conclusions
Theoretical Insights
The Effectiveness of Active Management and Alternative Assets
For the case studies evaluated, if safety of principal is paramount, then alternative assets
proves the inferior investment. Only three of the eight case studies managed to produce
less volatility – and only then at the sacrifice of risk-adjusted performance.
Alternative Asset Correlation
A purpose of this study was to measure the value of alternative assets in the absence of
top-decile management. Theoretically, an alternative-laden portfolio should outperform a
conventional portfolio in years of market crisis because of low correlation. However,
more often than not, this was not the case. (FY 2008 – the beginning of the sub-prime
crisis – was the exception.) Usually, the alternative-laden portfolios outperformed the
Swensen portfolios in FY2008. However, the record showed that an alternative-laden
portfolio outperformed the Swensen portfolio just 23.68% of the time. On the flip side,
the chance that a diversified model of index funds (the modified Swensen model) will
outperform an alternative-laden portfolio during a year in market crisis is 76.32%.
Utilizing an index-based portfolio serves as a better defense against market downturns
than alternative asset allocation.
‘Bad Year’ Performance Differential Relative Swensen Portfolio
Portfolio
Index
FY 2001
FY 2002
FY 2003
FY 2008
FY
2009
28
FY 2012
UHF
Swensen
N/A
N/A
N/A
1.23%
3.57%
-9.44%
WSUFEF
Swensen
N/A
N/A
-3.26%
4.53%
-0.73%
-7.34%
UNCW
Swensen
N/A
-7.60%
-3.99%
7.92%
5.89%
-1.64%
UCSBF
Swensen
-7.22%
-10.07%
-0.29%
-6.47%
-0.33%
-10.74%
UCIF
Swensen
-3.92%
-7.87%
0.61%
0.03%
-0.23%
-6.94%
UCRF
Swensen
-0.02%
-4.77%
-1.79%
5.73%
-1.73%
-9.94%
UCSFF
Swensen
-2.02%
-7.47%
-4.99%
-4.57%
3.87%
-8.24%
Portfolio
Index
Calendar Year
2009
2011
CSSO
Swensen
-10.92%
-8.37%
Key
Alternative-laden Superior Performance
Inferior Performance
Table 29 - ‘Bad' Year Performance Differential Relative Swensen Portfolio
28
The Swensen portfolio suffered from lackluster performance in FY 2008 and FY 2009, in part,
from its allocation to real estate.
Jon Luskin - MBA Thesis v4.docx Page 46
Conclusion
It if was not clear before this study that MMII should avoid active management and
alternative asset allocation, then it is now. On average, alternative asset allocation proved
riskier than a well-diversified indexed-based portfolio. As demonstrated in two previous
studies (Ferri 2012, Wallick, Wimmer and Schlanger 2012) actively-managed portfolios
provide lower returns than index funds. Moreover, active management usually resulted in
higher portfolio volatility as well. Additionally, alternative-laden portfolios are less likely
to produce superior returns during times of macroeconomic shocks. Risk-adjusted
performance was consistently higher with the index-based portfolios.
Why? All assets – even those with supposedly low correlation to traditional
assets, decline in tandem during macro-economic shocks (Harvard Magazine 2009,
Cambridge Associates LLC 2013). Holding alternatives – with their inherent illiquidity –
exacerbates this problem (Humphreys 2010). Thus, the conventional wisdom for holding
alternatives – low correlation to traditional assets – is simply inaccurate.
Jon Luskin - MBA Thesis v4.docx Page 47
Practical Recommendations
Swensen: The Superior Risk-Adjusted Portfolio
The Swensen portfolio outperformed the case studies. If there was an increase in risk, that
risk was compensated with an outsized return. In answering the question, “is it worth it?”
or, “is the risk worth the return?” the Sharpe and Sortino Ratios consistently answer
“yes.”
The question then is, “should endowments be taking this much risk?” This answer
is for those respective organizations’ Finance Committees to decide. That issue boils
down to what function an endowment plays in its respective organization.
Does the endowment serve to cushion the institution against financial crisis – to
act as a financial reserve and not be tapped annually for ongoing operational
support?
o This scenario may not be appropriate for the Swensen portfolio.
Is the investment portfolio simply a place to park cash from a capital campaign?
o This scenario also may not be appropriate for the Swensen portfolio.
Is the endowment regularly funding operational expenses?
o If an endowment continuously supports the operating budget of an
organization, then it is critical that the endowment principal grow with
inflation and the growth of the organization. Such a goal may require an
aggressive investment portfolio.
California Community Services Organization
For CSSO, the issue is clear: the portfolio manager is subtracting wealth from CSSO.
There is no benefit to maintaining CSSO’s existing investment strategy. CSSO
would be far better served by implementing a simple buy-and-hold strategy using
index funds. Relative CSSO’s existing portfolio, such a strategy would produce higher
returns, less risk, higher risk-adjusted returns, and superior performance against market
shocks.
University of Hawaii Foundation
UHF’s actively managed portfolio is giving up substantial growth in exchange for lower
volatility – sometimes. Yet, this level of safety may be inappropriate given UHF’s
unusually high distribution requirements. This is because the historic return is
problematic considering its payout ratio. UHF payout is calculated as “4.9% applied to
the twelve-quarter average market value” for the ending FY. This is in addition to a 1.5%
administrative fee charged by UHF (Wo, University of Hawaii Foundation 2011
Endowment Report). The combined withdrawal rate of 6.4% is actually three basis points
above UHF’s performance for the last nine years. This deficit of three basis points makes
no consideration for inflation.
Jon Luskin - MBA Thesis v4.docx Page 48
The Higher Education Price Index (HEPI)
29
measures inflation at 3.1%, over 10 years,
ending June 30th, 2012 (Commonfund Institute 2013). UHF’s aggressive withdrawal
rate, the endowment’s value is not keeping up with inflation (controlling for donor
contributions). Given UHF’s aggressive distribution rates, a more aggressive portfolio is
necessary for those distributions to keep up with inflation.
While the risk-adjusted performance of the Swensen portfolio measured higher
than UHF’s existing portfolio, the total risk may still be more than what UHF’s board is
willing to stomach. A solution may be to decrease equity allocation, and increase bond
holdings, in the index-based comparison portfolio.
Asset Class Allocations – Swensen Portfolios
Asset Class
Swensen
Swensen 65/30/5
Swensen 55/40/5
US Broad Market
30%
25%
17.5%
US REIT
20%
20%
17.5%
International Developed
15%
15%
15%
Emerging
5%
5%
5%
Treasuries
15%
15%
20%
TIPS
15%
15%
20%
Cash Equivalent
0%
5%
5%
Table 30 - Original and modified Swensen portfolios by asset class allocation
A bond-heavy Swensen portfolio holding a 40% allocation to government bonds
(nominal and inflation-linked) produces less risk and still higher return than UHF’s
alternative-laden portfolio.
Performance Metrics of Nine Consecutive FYs, ending June 30th, 2012
Portfolio
Annualized
Returns
Total Return
STD Dev.
Sharpe Ratio
Sortino Ratio
UHF Actual
6.37%
74.30%
11.7%
0.414
0.248
Swensen 65/30/5
8.86%
114.63%
13.6%
0.540
0.531
Swensen 55/40/5
8.85%
114.43%
11.6%
0.606
0.591
Table 31 - Greater allocation to bonds outperforms UHF's actual portfolio in every metric examined
Washington State University Foundation Endowment Fund
Consider that WSUFEF has a similar scenario to UHF. WSUFEF has aggressive annual
distributions of 5.5%
30
(Washington State University Foundation, National Association
of College and University Business Officers and Commonfund Institute 2012). With an
annualized return of 6.16% over the last 10 years, a distribution rate of 5.5% leaves only
0.66% for inflation annually. HEPI shows 3.3% annual inflation over the last 10 fiscal
29
Higher Education Price Index. HEPI grows in excess of the more traditional inflation index, the
Consumer Price Index (CPI). This is because some of the costs particular to higher education
cannot be decreased by an increase in efficiency (Swensen, Pioneering Portfolio Management).
30
It should be noted that the move from a 5% annual distribution to a 5.5% annual distribution is
a big jump – especially with respect to the risk of decreasing investment principal.
Jon Luskin - MBA Thesis v4.docx Page 49
years (Commonfund Institute). In order for WSUFEF to meet those requirements and
keep up with HEPI, WSUFEF will need to produce higher investment returns.
The bond-heavy Swensen portfolio produces superior returns relative the
alternative-laden portfolio while simultaneously undergoing less risk. (For this particular
time period, the bond-heavy Swensen bests the Swensen 65/30/5.)
Performance for 10 FY Returns, ending June 30th, 2012
Portfolio / Index
Annualized
Returns
Total
Return
STD
Dev.
Sharpe Ratio
Sortino Ratio
WSUFEF
6.16%
130.77%
12.16%
0.40
0.217
Swensen 65/30/5
8.56%
215.62%
12.87%
0.55
0.514
Swensen 55/40/5
8.70%
221.64%
10.97%
0.63
0.595
Table 32 - The Swensen 55/40/5 provides less risk and greater return than UHF's actual portfolio.
University of Northern California Wilmington
Similar to WSUFEF, UNCW’s investments offer less return for less risk when juxtaposed
to the Swensen 65/30/5. Unlike WSUFEF, UNCW may be best served by maintaining its
less risky portfolio. The reason being is the UNCW puts a smaller demand on its
endowment for operational support. UNCW’s withdrawal rates fluctuate between
relatively aggressive (4.5%) and conservative (3.5%)
31
– with UNCW voting to shrink
distribution rates as their investment principal recovers from the recent financial crisis
(Miller n.d.).
At the end of FY 2012, UNCW allocated 31% of its portfolio to fixed-income
securities (with as much as a 40% allocated in FY 2002). What qualifies as fixed income,
however, may be misleading. Roberta LaSure, the university’s foundation and
endowment accountant, explains:
… I’m reporting the asset classes used by our external fund managers, but these are mapped
somewhat differently to the asset classes per the NACUBO Endowment Study. The 31% fixed
income allocation includes cash…, certain real estate investments (included in alternative
strategies in bottom pie chart) and diversifying strategies…
What would performance look like if that fixed income allocation was not alternative
fixed-income, but conventional? Again, the index-based portfolio (55/40/5) outperforms.
Performance of 11 Consecutive FYs, ending June 30th, 2012
Portfolio /
Index
Annualized
Returns
Total
Return
STD
Dev.
Sharpe
Ratio
Sortino
Ratio
UNCW
6.77%
105.54%
10.72%
0.49
0.33
Swensen
65/30/5
7.81%
128.79%
12.49%
0.5
0.44
Swensen
55/40/5
8.11%
135.87%
10.61%
0.59
0.53
31
By one standard, 4% is an aggressive withdrawal rate (Cambridge Associates LLC 2013).
Jon Luskin - MBA Thesis v4.docx Page 50
University of California, Santa Barbara, Irvine, Riverside & San Francisco Foundations
All of the UC endowment portfolios would perform better by replacing the actively-
managed assets with indexed investments. The outcome would be not only greater
investment returns, but greater risk-adjusted investment returns.
Inside Management
The Swensen portfolio is so simple that professional money managers are unnecessary.
Rebalancing may only be required annually – if at all. Distributions and deposits could
counteract the effects of disproportionate growth of the asset classes making rebalancing
unnecessary. Using low-cost ETFs, the Swensen model could cost as little as 0.08%
annually. Consider that cost relative to the fees of 2% of AUM and 20% of returns.
Asset Class
ETF Ticker
ER
US Broad Market – 25%
SCHB
0.04%
US REIT – 20%
SCHH
0.07%
International Developed – 15%
SCHF
0.09%
Emerging– 5%
SCHE
0.15%
Long-term Treasuries – 15%
VGLT
0.12%
TIPS – 15%
SCHP
0.07%
Cash Equivalent – 5%
BIL
0.13%
Portfolio Total Expense Ratio
0.08%
Table 33 - Swensen Portfolio Expense Ratio
Potential Challenges of the Swensen Model in the Years Ahead
The period evaluated was distinguished by two successive market downturns, all under a
rising bond bubble. The Swensen model was so successful during the period partly
because of a 30% allocation to United States Treasuries. This enabled the portfolio to
take advantage of rising bond prices, and profitably rebalance at market downturns. A
future featuring rising interest rates, or a rallying equity market, (or lower volatility in
general), will likely produce lower returns for the Swensen model. How this index-based
portfolio performs in future periods is simply unknowable. What is knowable is that high
fees charged by active managers will net less investment return relative to a low-cost
index.
Additional Considerations
Board members can be trained on the principles of the failure of active management, the
exclusivity of top-decile managers, the increasing efficiency of alternative asset classes,
and the myth of low correlation offered by alternatives. In order for boards to make the
best decisions with respect to their endowments, they need be informed. Crafting an
appropriate Investment Policy Statement (IPS) can prevent boards from participating in
the herd mentality. A well-structured IPS focuses on the importance of maximizing
mission delivery. This will preclude an organization’s investment from being invested
into unproven asset classes (Vielhaber 2013).
Jon Luskin - MBA Thesis v4.docx Page 51
What this Study Adds to the Literature
Existing literature notes the superior returns of index-based portfolios in the absence of
top-decile management. However, these analyses did not consider the importance that
volatility plays in an endowment portfolio. With annual distribution requirements,
endowments often cannot afford to suffer multiple years of returns below 5%.This study
confirms that index-based portfolios not only produce higher investment returns, but do
so with lower volatility, and superior risk-adjusted performance. Based upon the case
studies, university endowments should carefully re-evaluate their existing investment
strategies.
Suggestions for Future Research
The small sample size of this study makes it challenging to apply the conclusion more
broadly. Future research can increase the sample size. The period examined was unique
because of falling interest rates and two successive market downturns. Re-evaluating the
performance of the Swensen model over the next 10 years could validate low-cost
indexing as an enduring strategy.
Further research could also evaluate why boards consistently put their assets into
unproven investments. This could be the counterpart to this paper, focusing on behavioral
finance. Researchers should examine the extent of influence professional investment
advisors have over board members, including potential conflicts of interest. Other points
of interest may include the herd mentality bias mentioned in Orientation on page 8.
Jon Luskin - MBA Thesis v4.docx Page 52
Works Cited
Asch, Burton A. Weisbrod & Evelyn D. Endowment for a Rainy Day. Magazine Article,
Stanford Review, 2010.
Bank of America. Bank of America | Profile – Company Facts – Vision & Future. n.d.
http://about.bankofamerica.com/en-us/our-story/our-
company.html#fbid=ekkG3dtTCVg (accessed November 25, 2012).
Barber, Brad M., and Guojun Wang. Do (Some) University Endowments Earn Alpha?
Draft, Davis, California: University of California, Davis, 2013.
Barber, Brad M., and Terrance Odean. "Trading Is Hazardous to Your Wealth: The
Common Stock Investment Performance of Individual Investors." The Journal of Finance,
2000: 773-806.
Bernstein, William. The Four Pillars of Investing: Lessons for Building a Winning Portfolio.
McGraw-Hill Companies, 2010.
Bhardwaj, Geetesh, Gary B. Gorton, and K. Geert Rouwenhorst. Fooling Some of the
People All of the Time: The Inefficient Performance and Persistence. Working Paper,
Cambridge, MA: National Burea of Economic Research, 2008.
Bogle, John C. The Little Book of Common Sense Investing. Hoboken, New Jersey: 2007,
2007.
Cambridge Associates LLC. The Risk Allocation Framework. Arlington, VA: Cambridge
Associates LLC, 2013.
Celati, Luca. The Real Liquidity Risks in Alternative Investments. January 2005.
http://www.eurekahedge.com/news/05jan_archive_Abraxas_Real_Liquidity_Risks.asp
(accessed October 10, 2013).
Commonfund Institute. 2012 HEPI: HIGHER EDUCATION PRICE INDEX. Update, Wilton,
CT: Commonfund Institute, 2013.
—. "Commonfund Hedge Funds." Commonfund Hedge Funds. Commonfund Institute,
October 2012.
—. "Nonprofit Healthcare Organizations Report." WILTON, CT: Commonfund Institute,
August 20, 2012.
Jon Luskin - MBA Thesis v4.docx Page 53
Commonfund Institute. Principles of Endowment Management: The seven key issues
facing trustees and financial officers. How To Guide, Wilton, CT: Commonfund Institute,
2006.
Conroy, Robert M., and Robert S. Harris. ""How Good Are Private Equity Returns?"." CFA
Digest, 2008: 96-108.
Ezra, Don. once-upon-a-time-nonprofit.pdf (application/pdf Object). September 2012.
http://www.russell.com/documents/institutional-investors/research/once-upon-a-time-
nonprofit.pdf (accessed 2012 25, November).
Fed Funds Target Rate History (Historical). 2013.
http://www.fedprimerate.com/fedfundsrate/federal_funds_rate_history.htm (accessed
September 23, 2013).
Ferri, Rick. The Curse of the Yale Model. April 6th, 2012.
http://www.forbes.com/sites/rickferri/2012/04/16/the-curse-of-the-yale-model/
(accessed 3 2013, April).
Governale, Nancy B. Gardiner & Marcia M. Charitable Giving: Asset Allocation Reporting
and Effective Philanthropy. Thinly vieled advertisement, Hemenway & Barnes, LLP, 2011.
Harvard Magazine. The endowment’s swoon | Harvard Magazine Nov-Dec 2009.
November 2009. http://harvardmag.com/pdf/2009/11-pdfs/1109-50.pdf (accessed
September 30, 2013).
Huebscher, Robert. The Futility of the Endowment Model. Summary of other works,
Lexington, MA: Advisor Perspectives, 2013.
Humphreys, Joshua. Educational Endowments and the Financial Crisis: Social Costs and
Systemic Risks in the Shadow Banking System; A Study of Six New England Schools.
Statistical Study, Boston, Massachusetts: Tellus Institute, 2010.
Jarvis, John S. Griswold & William F. "The Investment Policy Statement." Commonfun
Institute, August 2011.
Jones, Howard, and Jose Vicente Martinez. HOW INSTITUTIONAL INVESTORS FORM AND
IGNORE THEIR OWN EXPECTATIONS. Report, Oxford, United Kingdom: University of
Oxford, Saïd Business School, 2013.
Jorion, Philippe. Risk Management for Alternative Investments. June 18, 2012.
http://merage.uci.edu/~jorion/varseminar/Jorion-CAIA-Risk_Management.pdf
(accessed October 10, 2013).
Jon Luskin - MBA Thesis v4.docx Page 54
Keynes, John Maynard. The General Theory of Employment, Interest and Money.
London: Macmillan, 1935.
Kolhatkar, Sheelah. Hedge Funds Are for Suckers - Businessweek. July 11, 2013.
http://www.businessweek.com/articles/2013-07-11/why-hedge-funds-glory-days-may-
be-gone-for-good (accessed September 30, 2013).
Malkiel, Burton G. A Random Walk Down Wall Street. New York: W. W. Norton &
Company, 2012.
McCrum, Dan. The great diversification bait and switch. October 9, 2013.
http://ftalphaville.ft.com/2013/10/09/1661742/the-great-diversification-bait-and-
switch/ (accessed October 10, 2013).
McDonald, Michael. "Can Timber Rebuild Harvard's Endowment?"
BloombergBusinessWeek. September 20, 2012.
http://www.businessweek.com/articles/2012-09-20/can-timber-rebuild-harvards-
endowment#p2 (accessed 6 2013, February).
Meketa Investment Group. Rebalancing. web report, Boston, MA: Meketa Investment
Group, 2010.
Mendillo, Jane L. Harvard Management Company Endowment Report. Endowment
Report, http://www.hmc.harvard.edu/docs/Final_Annual_Report_2012.pdf: Harvard
Management Company, 2012.
Merrill Lynch Center for Philanthropy & Nonprofit Management. Nonprofit Guide to
Prudent Investing. 2009.
http://www.michiganfoundations.org/s_cmf/bin.asp?CID=2523&DID=35905&DOC=FILE.
PDF (accessed November 25, 2012).
Miller, Gary L. Endowment Activity Report. Endowment Report, Wilmington: UNCW
Office of University Relations, n.d.
Moody's Investor Service. One Third of US Colleges facing falling or stagnant tuition
revenues. Press Release, New York, New York: Moody's Investor Service, 2013.
Morien, Travis. Index funds vs active funds. n.d.
http://www.travismorien.com/indexactive.htm (accessed October 2, 2013).
National Association of College and University Business Officers and Commonfund
Institute. NACUBO-Commonfund Study of Endowments. Statiscal Survey, Washington
Jon Luskin - MBA Thesis v4.docx Page 55
DC: National Association of College and University Business Officers and Commonfund
Institute, 2012.
Nelson, Eric D. "Lessons From the Big Money." Servo Wealth Management. July 2012.
http://www.realclearmarkets.com/blog/July%202012%20Factors%5B1%5D.pdf
(accessed April 3, 2013).
OpalesqueTV. Mark Yusko: The Endowment Model isn't broken - Opalesque.TV. May 19,
2010. http://www.youtube.com/watch?v=_OiO5Avv3bw (accessed November 26,
2012).
Parness, Michael. Rule the Freakin' Market. New York: St. Martin Press, 2002.
Principles of Nonprofit Investment Management: The key issues facing trustees and
financial officers. online publication, Wilton, CT: Common Fund Institute, 2006.
Richardson, Eric W., and Mebane T. Faber. The Ivy Portfolio. Hoboken, New Jersey:
Wiley, 2009.
Russell Investments. Russell Index Performance Calculator | Russell Investments. n.d.
http://www.russell.com/indexes/data/calculator/index_calculator.asp (accessed April
3rd, 2013).
Stanyer, Peter. Guide to Investment Strategy: How to Understand Markets, Risks,
Rewards and Behavior. New York: Bloomberg Press, 2010.
Steele, Grant, William Prout, and Courtney Larson. Spending Policy Practices. Statical
Survey, Arlington, VA: Cambridge Associates, LLC, 2012.
Swensen, David F. "Guest Lecture by David Swensen." New Haven, CT: YouTube, on
behalf of Yale University course Financial Markets (ECON 252), November 9, 2008.
—. Pioneering Portfolio Management. New York, New York: Free Press, 2009.
—. Unconventional Success: A Fundamental Approach to Personal Investment. New
York: Free Press, 2005.
Tellus Institute. Josh Humphreys - The Tellus Institute for a Great Transition. 2012.
http://www.tellus.org/about/Humphreys.html (accessed November 28, 2012).
The Responsible Endowment Project. Realizing Responsibility: A Modern Responsible
Investment Framework for the Yale Advisory Committee on Investor Responsibility.
Essay, New Haven, CT: The Responsible Endowment Project, 2010.
Jon Luskin - MBA Thesis v4.docx Page 56
The Responsible Endowment Project. Responsible Returns: A Modern Approach to
Ethical Investing for the Yale Endowment. Essay, New Haven, CT: The Responsible
Endowment Project, 2009.
Towers Watson Investment Services. Asset Allocation Considerations for Nonprofits.
Towers Watson, 2010.
Tuttle, Matthew. How Harvard and Yale Beat the Market. Hoboken, NJ: John Wiley &
Sons, 2009.
Vielhaber, Steven, interview by Jon Luskin. (October 12, 2013).
Wallick, Daniel W., Brian R. Wimmer, and Todd Schlanger. Assesing endowment
performance: The enduring role of low-cost investing. Valley Forge, CA: Vanguard, 2012.
Washington State University Foundation. WSU FOUNDATION. Endowment Report,
Pullman: Washington State University Foundation, n.d.
Weinman, Lawrence. Sensible Investments. December 20, 2012.
http://www.sensibleinvestments.blogspot.com/search?updated-max=2013-01-
24T10:24:00-08:00&max-results=7 (accessed 16 2013, February).
Wo, C. Scott. University of Hawaii Foundation 2011 Endowment Report. Endowment
Report, Honolulu, HI: University of Hawaii Foundation, n.d.
Wo, C. Scott. University of Hawaii Foundation 2012 Endowment Report. Endowment
Report, Honolulu, HI: University of Hawaii Foundation, n.d.
Yale Endowment. 2012 Yale Endowment. Endowment Performance, New Haven, CT:
Yale Investment Office, 2012.
Yale News. "YaleNews | Yale Endowment earns 4.7% investment return." Yale News.
September 27, 2012. http://news.yale.edu/2012/09/27/yale-endowment-earns-47-
investment-return (accessed January 11, 2013).
Jon Luskin - MBA Thesis v4.docx Page 57
Appendices
Jon Luskin - MBA Thesis v4.docx Page 58
Appendix A: Indexing vs. Active Management
All stocks offered for trade in the stock market generate a group return. A measure used
to track the performance of a group of assets is called an index. One commonly used
index is the Standard & Poor’s 500 (S&P 500). The S&P 500 tracks the stock
performance of some of the largest publicly-traded companies, and is broadcasted daily
across radios, televisions and the internet: “S&P 500 down 5 points today in trading, at
the closing bell.”
The S&P 500 is just one of many indices. There exist other indices, like the Russell 2000,
which tracks the performance of the stocks of 2,000 small companies. The Wilshire 5,000
tracks the returns of almost every single domestic company stock on offer. The Wilshire
5,000 includes large companies, small companies, and everything in between. A
comprehensive index like the Wilshire 5000 is called a broad market index.
Asset Class
Index
Domestic Large Capitalization
Dow Jones Industrial Average (DJIA)
Domestic Large Capitalization
S&P 500
Technology Stocks
Nasdaq
World Large & Mid Capitalization
MSCI World Index
Domestic Small Capitalization
Russell 2000
Domestic Broad Market
Wilshire 5000
Domestic Real Estate
Dow Jones U.S. Select REIT Index
International Markets
FTSE Developed ex-US Index
Emerging Markets
FTSE Emerging Index
International Real Estate
S&P Global ex-U.S. Property Index
Domestic Fixed Income
Barclays Aggregate Bond Index
Table 34 - Common Asset Class Indices
An investor can invest in an index fund – that is, put money into an investment vehicle
that tracks, follows, or mimics the return of a specific index. An investment in an S&P
500 index fund is an investment in the 500 companies making up the S&P 500. With an
index fund, the investor gets exposure to the aggregate investment returns of those
companies. This is a much easier and usually cheaper strategy than purchasing individual
shares in all 500 companies.
Why is this method easier and cheaper? There are several reasons. Firstly, the
stock market, in aggregate and on long timelines, has showed consistent returns, far in
excess of inflation (Bogle, Swensen, Stanyer).
32
On a long enough timeline, it is virtually
guaranteed that an investment in the broad market will appreciate in value. For shorter
timelines, anything is possible – including loss of principal of up to 90% - as was case in
the Great Depression (Swensen 2008).
32
Since the 1920s, when data appropriate for later analysis was first recorded.
Jon Luskin - MBA Thesis v4.docx Page 59
Secondly, index investing, or indexing,
33
offers a low cost way to invest. Imagine the fees
required to execute the 500 trades necessary to capture the performance of the S&P 500.
With an index fund, an investor can make a single trade to purchase a product that tracks
the performance of the entire index. For this convenience and value, the investor pays a
small expense ratio (ER): a percentage of assets (money) under management. Sometimes
these fees are as small as 4 basis points, or 0.04%.
34
To put this number into context,
consider that the expense ratio on an actively-managed fund can be upwards of 2% - or
literally 50 times as much.
But why would an investor want to hold stock in as many companies as offered
by the S&P 500 index? The answer therein illuminates the third reason to invest in an
index: to reduce risk.
Modern Portfolio Theory & Diversification
The premise of investing in a multitude of assets
35
is called diversification. Modern
Portfolio Theory (MPT) – one of the modern dominant investment strategies – posits that
with diversification, an investor can have equivalent returns for less risk – or greater
returns for equivalent risk. Diversification is accomplished by adding distinct assets to
the investment portfolio. An investment in a Wilshire 5000 index fund realizes the
diversifying power of the entire United States stock market. Were an investor to hold a
Wilshire 5000 index fund, that investor would generate market returns minus the cost of a
small expense ratio.
Consider the value of diversification with the following example: An investor
purchases the stock of five different companies. Now, imagine that one of those
companies goes out of business; or loses value because of government regulation or a
loss of market share to a competitor, etc. The investor just suffered a hit to 20% of their
portfolio.
Figure 19 – From left to right: a visual representation of a non-diversified, and diversified portfolio, respectively
Now, consider that instead of investing in just five companies, the investor chose to buy
an investment product that tracks the performance of the S&P 500. In the instance that
33
Sometimes also referred to as passive management – though there is a distinction between
indexing and passive management.
34
Charles Schwab Broad Domestic Broad Market Index Exchange Traded Fund (ETF), ticker
SCHB :NYSE Arca.
35
Company stock is one class (type) of asset. Bonds are another class of assets.
Jon Luskin - MBA Thesis v4.docx Page 60
one, or even two, of those companies in the S&P 500 lose value, the investor would not
even blink. This is because the slice of the portfolio affected by the poorly-performing
companies is so small relative the total value of the portfolio. In summation, index
investing offers a low-cost way to generate market returns, with less risk than holding
individual companies alone.
Active Management
The alternative to index investing is active management. Active management is the
practice of investment picking. It is selecting those investments that the manager
discovers, through extensive research or otherwise,
36
presents the best yield opportunity.
Stock picking, or security selection, offers the promise of market-beating returns. Thus,
active management purports to find those higher-performing stocks, giving the investor
market-beating, or above average, returns over time. Active management is the
alternative to indexing, where an investor reaps exactly what the market in aggregate
produces.
37
The challenge is that the active manager must select those stocks before they
rise in value.
How is outperforming the market’s aggregate – ‘beating the market’ – possible?
The subject was touched on earlier, when the premise of diversification was discussed.
While diversification reduces risk by holding as many companies as possible,
concentration increases risk by holding a select group of companies (or investments) that
the money manager feels will outperform the market average. If a money manager can
skillfully select just those ‘winners,’ the money manager will outperform the market
average.
Consider an example with respect to the following line graph Figure 20 -
Performance Snapshot of Four Companies. At the close of 2008, the successful money
manager would have had the foresight to purchase the stock of Berkshire Hathaway
(green) and Johnson & Johnson (yellow), while avoiding the stock of ExxonMobil (red)
and General Electric (purple). (Conversely, an index fund would invest in all those
companies and more.)
Figure 20 - Performance Snapshot of Four Companies
36
i.e. quantitative analysis.
37
Minus a small fee.
Jon Luskin - MBA Thesis v4.docx Page 61
Active management – also known as stock picking or security selection – is inherently
more risky than index investing. Selecting individual companies from a larger body
means that the investor’s portfolio is now more susceptible to loss given the bad luck of
just a single company (recall the previous pie graph illustration in Figure 19 – From left
to right: a visual representation of a non-diversified, and diversified portfolio,
respectively). On the other hand, all else being equal, an active-management – or stock
picking – strategy is more susceptible to outsized gains. Therein lies the classic
conundrum, as posited by Modern Portfolio Theory. All else being equal, greater returns
can only be had by enduring greater risk.
In addition to assuming greater risk because of greater relative volatility, active
management has another disadvantage: high fees. So, even if a money manager performs
poorly, the investor must still pay for those services. Further, in the event a professional
money manager outperforms the market (benchmark), he will need to outperform the
market by his investment fund’s expense ratio just to break even. To put this into
perspective, know that producing market returns in excess of even 1% on a long timeline
is a rare feat (Bogle; Swensen; Stanyer).
Why is it so difficult to ‘beat the market?’ It is simple math. The median (index)
is a division that evenly separates a population (stocks): half the population lands above
and half the population falls below that division. Sheer statistics dictate that when picking
one sample from the population, that selected sample has a 50% chance of being either
above or below the median. Mathematically, there is no way around that. When it comes
to investing, above average picks cancel out below average picks. After pulling several
samples (stocks) from the population (market), the money manager has generated market
returns. The fees charged by the money manager will leave the principal with below
market returns.
The above ignores one variable: skill. Money managers practicing stock-picking
should have some special ability to predict which companies will appreciate in value
above others. The literature review, however, has shown this is not the case for 90% of
money managers –after accounting for the cost of fees. While there will always be
outliers who will perform exceptionally over extended periods of time (the top-decile),
these skilled individuals are usually not available for hire – at least not by investors with
finite assets (Swensen). In fact, these highly skilled top-decile money managers – those
individuals who can beat the market after accounting for fees – are not even available to
those institutional investors with hundreds of millions of dollars. Market-beating skill can
only be acquired with billions of dollars of AUM. Thus, the only money managers
available for hire are those whose performance trails the market index after accounting
for fees. Unfortunately, after subtracting the high cost of fees, sub-75 percentile skill does
not generate market-beating returns (Swensen).
The logical conclusion is that an investor is best served by buying a low-cost
index fund. The index fund strategy will produce market returns by avoiding the
transaction fees and high expense ratios (ER) of active management.
Jon Luskin - MBA Thesis v4.docx Page 62
Appendix B: Risk-Free Rate
FY ending June 30th
Risk Free Rate
2012
0.25%
2011
0.25%
2010
0.25%
2009
1.87%
2008
3.77%
2007
5.25%
2006
4.18%
2005
2.17%
2004
1.00%
2003
1.42%
2002
2.31%
2001
5.74%
2000
5.60%
1999
4.98%
Calendar Year
Risk Free Rate
2012
0.25%
2011
0.25%
2010
0.25%
2009
0.25%
2008
2.09%
2007
5.05%
2006
4.96%
2005
3.19%
2004
1.34%
2003
1.12%
Jon Luskin - MBA Thesis v4.docx Page 63
Appendix C: Basic Investing Principles Glossary
Investment return is the return an investor receives for their investment. Returns are
extremely variable, ranging from a total loss of capital (-100%) to infinite growth.
Returns are expressed as percentage of the original investment capital. For example, a
$10 return on an investment of $100 is a return on investment of 10% for the period
measured.
Investment returns are posted relative a period. That period can be as a short as less than
one second, or as long as infinity.
A FY varies by reporting agency. Academic institutions usually run on a FY running
from July 1
st
through June 30
th
of the following year. For example, FY 2012 will describe
the period from July 1
st
, 2011 to June 30
th
, 2012.
Total Return is the return an investor receives during the period measured. This includes
the appreciation in an asset’s value, as well as the value of any dividends/coupon
payments or capital gains/appreciation during that time.
Annualized Return is the return an investor receives over a period, expressed as a time-
weighted annual percentage. Said another way, annualized return is the return an investor
receives each year when compounded over the previous year’s return. For example, an
investment produced the following consecutive calendar year returns:
Year
Return
Investment Value
Return
Investment Value
2009
$ 100.00
$ 100.00
2010
5%
$ 105.00
3.14%
$ 103.14
2011
10%
$ 115.50
3.14%
$ 106.38
2012
-5.00%
$ 109.73
3.14%
$ 109.73
Total Return
9.73%
9.73%
Annualized Return
3.14%
3.14%
Table 35 - Annualized Return
Note that for the portfolio on the left, returns vary from year. The portfolio on the right,
however, has a consistent return.
Diversification is the principal of holding as many as assets (and asset classes) as
possible to reduce risk. The idea behind diversification is that while one asset may
decline in value, a different asset will simultaneously increase in value (or decrease less).
An asset class is a category of assets. Some examples of assets classes are stocks, bonds
and cash. Each of those classes can be further broken down. For example, stocks can be
differentiated between large company stocks and small company stock. That can be
further broken down. Large company stocks can be divided between those with a high
Jon Luskin - MBA Thesis v4.docx Page 64
prospect for earnings growth (large growth stocks) and those companies whose stocks are
attractively priced, representing a good value for the investor (large value stocks). Other
examples of asset classes include emerging market stocks, like those from Brazil, Russia,
India or China.
Modern Portfolio Theory posits that higher returns can be had for equal risk through
diversification. Alternatively, equivalent returns can be had for less risk. For example, a
portfolio of a mix of stocks and bonds will outperform a portfolio of 100% stocks or
100% bonds. This concept is covered in greater detail in the literature review.
A premise of Modern Portfolio theory is that Risk vs Return is the quintessential trade-
off in investing. Higher returns can be had for bearing more risk. Stocks and bonds are an
example of this. While stocks perform better over a long-enough time than bonds, stocks
do so with greater risk, producing a higher variability in returns.
Rebalancing is the process of selling assets that have appreciated value so as to purchase
assets that have depreciated in value. Rebalancing effectively has an investors buying low
and selling high. Annual rebalancing is customarily recommended.
38
Passive Management or Indexing is the process of investing in a fund that represents
the total of an asset class, or representative sample of that asset class, for purposes of
riding the market waves, earning the average of all security returns. Mutual funds or
Exchange Traded Funds (ETFs) composed of the S&P 500 are the most common vehicles
utilizing indexing.
An Index fund is a mutual fund or Exchanged Traded Fund (ETF) that tracks an index.
Expense ratios are usually minimal, between 20 and 4 basis points (0.2% and 0.04%).
An Expense Ratio is a fee for service, expressed as a percentage of assets. Mutual funds,
exchanged traded funds (ETF), and portfolio managers charge varying expense ratios.
A Basis Point is one hundredth of a percent, or 0.01%.
Active Management, or active investing, is the process of picking specific positions
(securities) in the hopes that those positions will outperform the market aggregate.
Thousands of mutual funds offer active management, wherein money managers pick
particular companies they think will outperform the respective benchmark. Active
management, as reported by the literature review, shows a 99.2% failure rate to meet the
benchmark/index after fees (Bogle).
A Benchmark is a return metric serving as a reference point, though usually as a hurdle.
For example, an actively managed mutual fund will use the S&P 500 as a benchmark.
38
Yale Chief Investment Officer, David Swensen, father of the Endowment Model of Investing,
rebalances the Yale Portfolio daily not so much as measure to generate to profit but as to reduce
risk.
Jon Luskin - MBA Thesis v4.docx Page 65
Returns above that benchmark show that the mutual fund manager is performing
exceptionally well.
Fees are a critical element of any investment. The difference between a 5% and 6% on a
$100 million investment return over 30 years is a difference of $142 million dollars.
Alternative Assets classes are those assets that do not fit into one of the three stock,
bond, or cash-equivalent categories. Some examples of alternative assets include real
assets (commodities and real estate), absolute return (hedge funds, long-short equity) and
private equity (venture capital, and mergers & acquisitions).
AUM: Assets under management
Jon Luskin - MBA Thesis v4.docx Page 66
Appendix D: 60/40 Benchmark
Composed of 60% equities (stocks) and 40% bonds, the 60/40 is a commonly used
benchmark. For the purposes of the case studies to follow, this benchmark will be
composed of 60% S&P 500, and 40% Barclays US Government bond index, rebalanced
annually.
The Barclays US Government bond index, and not the Barclays Aggregate bond index
(which includes corporate and securitized bonds in addition to government bonds) is used
because non-profit organizations traditionally invested in a mix of corporate stock and
government bonds (Ezra).
Figure 21 - Convectional 60/40 Benchmark
Corporate
Stocks
60%
Long Term
Treasuriers
40%
60/40 Benchmark
Jon Luskin - MBA Thesis v4.docx Page 67
Appendix E: Digest of the Literature
Pioneering Portfolio Management
David Swensen, 2010
Type of Work: Case study
About the Author(s): Yale endowment’s Chief Investment Officer, creator of the
Endowment model of investing
Summary of the Scope, Approach, and Research Method: Discusses his approach to
endowment management
Summary of Key Findings or Insights
Asset allocation is the most important decision.
Market timing and security selection (without expertise in active management)
failed to add to portfolio returns.
Spending rules work best with an averaging process of previous returns.
Higher Education Price Index (HEPI) is 1.4% higher than Consumer Price Index
(CPI) historically.
Portfolios should have equity bias makes for higher returns and diversification to
reduce risk.
Illiquid assets usually fail to return on a risk-adjusted basis when considering thhe
cost of illiquidity.
Use passive management (index) for efficient market and active management for
inefficient markets, such as alternatives.
Higher interest rates usually lead to lower stock prices.
Rebalancing is a tool for reducing risk, not enhancing returns, though it can
enhance returns, just don’t count on it.
Not rebalancing is the equivalent of market timing, a proposition that usually fails
more than not.
Finding good active management in illiquid market is easier and more profitable
than doing the equivalent in liquid markets.
Asset class correlations in economic downturns are unusually higher pg 129
Swensen posits that no asset class should be more than 30 percent of the portfolio,
not less than 5 percent, with at least 6 distinguishing asset classes. pg 101.
Below investment grade bonds are not worth investing in. pg 102
Mean variance analysis fails to incorporate fat tails or black swan events into its
analysis, assuming a bell curve distribution of returns, which is inaccurate.
During particular periods of time, mean-reversion fails to exemplify itself. Pg 108
There is no benchmark for alternatives. pg 112
Stock and bond correlation is low, or low or negative, during inflation and
deflation respectively. pg 118
Real estate has bond- and equity-like characteristics pg 121
Traditional asset classes derive returns from the market as a whole, not active
management. p152
Government backed U.S. Treasury bonds create diversification power.
o Avoid GSE debt
Foreign holdings improve diversification.
Jon Luskin - MBA Thesis v4.docx Page 68
Alternative asset classes fail to produce results for risk adjustment without
superior active management.
Correlation of alternatives to marketable securities increases during down trends,
otherwise there is relatively low correlation, thus good diversification.
There is a greater spread in returns relative the best and worst active managers in
alternatives vs. marketable securities.
Survivorships bias skews results on alternative assets as a class.
Alternatives asset class fees present a hurdle to investors in generating returns.
Significant co-investment on part of the fund manager is a way to align fund
manager and investor interest.
Commodity indexes fail to provide the value that owning real assets do.
Holding foreign bonds expose investors to currency exchange risk.
Timberland is the one alternative that does not need superior active management.
The best active managers for venture capital are not accepting new investors.
Thus, do not invest in this category.
Posits that entrepreneurial investment managers are the best bet in active
management.
Posits that existing active management structure incentivizes management to
pursue growth of assets under management, not investment returns.
Active management investing via a large financial institution creates a whole
range of conflicts of interest. It is best to avoid doing so.
Co-investment serves to align fiduciary and investor interest, the larger the co-
investment, the better.
Soft dollars are a scheme that saps investor wealth, not disclosed in a stated
prospectus.
Selecting the appropriate active manager is critical to achieving investment
returns. Entrepreneurial firms with a deal structure that has them act as fiduciaries
are the best bet.
While active management offers the opportunity for generous returns, institutions
that attempt active management w/o the sufficient resources face disappointing
results. pg 297
Investments must be made with consideration for spending pay out pg 306
Fund of funds pose risks, including an additional layer between investor and
manager. Problematic is trusting someone’s else judgment on the worth of an
active manager, someone else who has less incentive to perform due diligence
than the investor themselves. pg 310
Consultants that offer investment services have an inherent conflict of interest. pg
314
Asset allocation, the most important decision, needs be reviewed only annually,
and not in response to a recent market crisis. pg 315
Quantitative analysis should be used in conjunction w/ qualitative analysis when
defining risk. pg 335
Jon Luskin - MBA Thesis v4.docx Page 69
A Random Walk Down Wall Street
Burton G. Malkiel, 2007
Type of Work: Scholarly synthesis
About the Author(s): Professorship’s Chairman at Princeton, served on board of
Prudential and Vanguard
Summary of the Scope, Approach, and Research Method: Explains investment
principles and best course for lay investor.
Summary of Key Findings or Insights
Individual investors are best suited to buy and hold an index mutual fund over
trading securities or using an actively managed fund.
Intrinsic value theory: everything has intrinsic value. When an item is
inappropriately valued by the market, there is the opportunity to buy or sell it.
Based on Graham and Dodd in Security Analysis.
Castle in the air theory: analyze crowd expectations and invest in securities before
they appreciate.
Malkiel explains a scheme in the roaring twenties wherein day traders worked
together to artificially inflate the price of stock. Malkiel also explains the tulip
bulb in Holland in 1700’s and the English South Sea Bubble of the 1800’s.
o In all these instances, buyers purchased speculative securities that rose in
price only to quickly crash.
o The governing SEC body played the only card it had, enforcement of
disclosure, which served to do nothing to prevent the market waves and
crashes.
In one bubble, conventional blue chip stocks (Nifty-fifty) were overvalued.
During the IPOs of the 80s (biotech), new valuations methods were computed to
presume earnings for a company that not only had no revenue to speak of, but no
product as well.
At many instances, the market inflates on the presumption that someone will buy
an obviously over-valued position at a later time – the castle in the air, or greater
fool theory.
Japan’s rise in real estate and securities rose on the false premise that the stock
and real estate markets could only go up.
The internet bubble also created new and useless valuation methods to justify the
prices of worthless IPOs.
Bubbles are a positive feedback loop, with overvalued securities moving onto
greater fools. Eventually, you run out of greater fools.
Wall Street firms, traditionally divided their research and investing departments.
This process was watered down, making for the offering of overvalued IPOs.
Media added to the frenzy of the internet bubble.
Historically, new tech securities have proven overvalued, from the internet to the
railroad.
In the short run, stock prices are impossible to predict.
Technical analysis looks at stock patterns, and is based upon the greater fool
theory.
o Technical analysis may not work because those using the paradigm may
move to slowly too take advantage of market trends
Jon Luskin - MBA Thesis v4.docx Page 70
Fundamental analysis is based on the firm foundation theory, evaluating a stock
on the basis of its assets, growth potential, etc.
o The market gives higher value to those securities with greater growth
potential as evidenced by a higher price/earnings (P/E) ratio.
o Posits that fundamental analysis consistently fails to accurately gauge
future stock value. The basis for fundamental analysis is earnings growth,
which is impossible to predict successfully.
There is inherent conflict of interest in analysts’ predictions, as brokerage firms
issue IPOs.
To buy and hold an index fund produces better returns, on average, than a mutual
fund that is actively managed. pg 178
Mutual fund managers have consistently failed in market timing efforts. – pg185
Investors bear greater return for greater risk. p200
With MPT, one can decreasing risk by adding risker, less correlated assets to a
portfolio.
However, when markets are down, correlation increases. pg210
Diversification can reduce some (unsystematic) risk. But systemic risk still exists.
There is not perfect risk metric. – pg 232
Countless technical analysts, but most academics, do indeed discover statically
profitable patterns in the market. However, while they work on paper, they fail in
reality due to trading costs or proliferation of knowledge of the technique. Pg 300
Small cap stocks show historically higher returns, rewarding investors for bearing
greater risk. More recent returns of small caps have not demonstrated this.
Market prices are based on expectations, which often turn out to be incorrect pg
298
Real estate is an inflation hedge, has low correlation w/ other assets pg 327
Low interest rates = stocks w/ low dividend yield and high price earning multiples
pg 342
High interest rates = high dividend yields and low price-earnings multiples
Stock returns are determined by dividend yield at time of purchase, growth rate of
earnings, and change in valuation via price-earnings or price dividend ratios pg
346
Alternative investments have tended to be negatively correlated to the stock
market. pg 349
Says rebalancing can add to a portfolio by over 1% a year. – pg 370
Weaknesses and Limitations
When reviewing some of the newer risk metrics, Malkiel fails at the opportunity
to assess their accuracy, as he does with other theories/ideas in the rest of his
book. Given his thoroughness, it is surprising he does not do so.
Malkiel argues for dollar cost averaging (DAC), and at the very least, keeping a
reserve to take advantage when prices sink. Swenson, however, makes a strong
argument against market timing, which in all instances, he says, fails. Pg 369
Other Comments
Jon Luskin - MBA Thesis v4.docx Page 71
Malkiel’s approach, humorous and thorough, does a good job of always analyzing
the issue.
Malkiel and Swensen differ on some issues: like that of high yielding (junk),
corporate and tax free bonds. Swensen makes the case that these instruments have
no place in in an investor’s portfolio. Malkiel disagrees. Swensen goes into much
greater detail as to “why not.” Malkiel briefly mentions it. As such, Swensen’s
argument is much more compelling.
Malkiel suggests adjusting asset allocation dependent upon one’s time horizon.
Swensen makes no such suggestion, giving a one-size-fits-all approach. Malkiel,
who goes into greater detail for his argument, is more convincing.
Guide to Investment Strategy
Peter Stanyer, 2010
Type of Work: Scholarly synthesis
About the Author(s): “Economist and strategist” at a “private wealth manager,” and
serves on investment committees at two pension funds and a college endowment
Summary of the Scope, Approach, and Research Method: A sort of investing 101
Summary of Key Findings or Insights
Posits investors are subject to loss when they do not comprehend the true nature
of risk associated with investments. pg6
References a study that states that the volatility of assets matters to investors, not
just the end value of the investments. pg 7
Attempts by advisers to asses an investor’s (client’s) risk can fail (when using a
questionnaire), as the investors, unfamiliar with investing, leans on the adviser for
help.
The adviser, with a greater tolerance for risk, pushes the investor towards riskier
investments.
Like Swensen, Stanyer advises investing into those assets where the investor has
expertise. In the absence of that, diversify. Pg 11
Self-attribution – investment success is due to skill. Lack of success is due to
misfortune. pg 16
Increasing amount of information will steer investors towards using mental
shortcuts, because the breadth of information is impossible to process. pg 17
Behavioral finance: mental accounting: separate assets by different purposes via
different tolerances for risk. This is unlike traditional finance. pg 24
Prospect theory: people will take huge risks to defer loss but will quickly
capitalize on gains pg 19
Term premium: the rate difference in long treasury bonds vs short treasury bills to
lure investors into the higher risk of the longer time horizon pg 29
Inflation risk premium: compensation for expected inflation AND the risk that
actual inflation may be higher than expected. pg 30:
Suggests the investor have more or less inflation indexed relative conventional
bonds as that investor anticipates more or less inflation. Pg 35
Prevailing view that 21
st
century may post less rewarding equity returns than the
20
th
century pg 42
Jon Luskin - MBA Thesis v4.docx Page 72
There is the risk of equities underperforming bonds over 5, and even 20 year,
timelines.
Bonds serve less a role for income generation than for diversification in a
portfolio. pg 58
Argues for diversified bond maturities. pg 56
Posits that time horizon and risk tolerance are distinct. There is a such a thing,
says Stanyer, as a long-term cautious investor. pg 61.
Dips from volatility can be seen as buying opportunities. pg 30
Posits cash is more risky in the long term than TIPS. pg 70
Bond ladders mitigate interest risk, relative to a fixed annuity. Bonds should be of
government quality pg 71-2
Change in strategy involves unavoidable market timing. pg 80
Illiquidity requires a premium for returns pg 91
With great skill, inefficiency can also be profited from, because these anomalies
are difficult to arbitrage. pg 93-5
Fundamental risk, noise trader risk and transaction fees are barriers to exploiting
inefficiencies pg 94-8
Small cap and value stocks have tendency to outperform the market. Pg 107
But since the observation the value of small caps stocks has been bid up pg 111
Overweighting small & value stocks is for aggressive investors pg 117
International equity provides diversification and opportunity
A little diversification into international equities goes a long way pg 122
Correlation of International equities to domestic has been increasing pg 123
Company management sides with equity over bond holders pg 128
Agrees with Swensen in that rating agencies fail to go do a good job on bonds pg
129
A high yield bond fund can help diversify individual, but not systemic, risk pg
134
Emerging market debt is similar to US equities in volatility, but more susceptible
to sudden shocks pg 136
Mortgage securities fail to provide assurances of those of gov’t bonds in exchange
for a premium pg 140
Hedging international bonds against the US dollar decreases the volatility of
returns pg 147
Currency exchange is highly volatile with no expected pay off pg 149
Hedge funds are lightly regulated pg 151
Co-investment, the ability to short, and opaqueness, define hedge funds
Hedge fund performance data is skewed positive pg155
Hedge fund can switch to an asset gathering strategy pg156
Diversification, via the addition of a wholly risky asset, is an attraction of hedge
funds as an investment/asset class pg158
With exception of hedge funds dedicated to short selling, hedge funds success
correlates with market success. pg 171
Incentive structures of hedge funds prompt them to close their doors, and
management start a new, than work to earn back previous losses pg 173
Jon Luskin - MBA Thesis v4.docx Page 73
Fund of funds have to overcome an additional layer of fees, while hedge funds
already charge high fees pg 178
Avoid private equity without the presence of superior active management pg185
Should be part of an investor allocation to equity
Illiquid, not for short term investors
Investors should expect a premium return for leverage in private equity
Fund of funds may fail to diversify away high volatility from leverage p193
One study found private equity to match the returns of the S&P 500 pg 194
Failing to compensate investors with a premium for the higher risk involved
pg195
Real estate performance is determined by investor skill, market performance and
leverage level pg 197
Manager skill can be misestimated given leverage
Real estate offers premium/secure yields, inflation protection and total return pg
201, 206
REITs are typically leveraged 40 to 60%
Property value is reflected in the future rental stream pg 208-9
International real estate should be currency hedged pg213
In what has been deemed an unrepresentative study, art has tracked inflation pg
215
Art has no basis for value, where equities have fundamentals
Manager performance needs to be evaluated against the appropriate benchmark
pg242
There exist conflicts of interest from financial advisors who sell products pg248
Weaknesses and Limitations
Explains the investors have more or less inflation indexed relative conventional
bonds as that investor anticipates more or less inflation. Pg 35 – why not take out
all the guess work and just have an even split of both? Given Malkiel’s random
walk, it seems unlikely than anyone can predict the market.
Cites the many weakness of municipal bonds, but does not ardently oppose them
as Swensen does pg 73
Oddly, and briefly, suggests outsourcing market timing to a professional pg80.
Yet expands upon the difficulty of successfully executing market timing.
Does not give sufficient argument against currency swaps
Other Comments
Would have been interested to see what the risk rate was for under performance of
equities relative bonds over 30, and 40 year timelines.
A Hard read.
Agrees with Swensen in that equity holders are put ahead of bond holders.
Jon Luskin - MBA Thesis v4.docx Page 74
The Little Book of Common Sense Investing
John C. Bogle, 2007
Type of Work: Conceptual Model
About the Author(s): Former CEO & founder of Vanguard group, father of indexing
Summary of the Scope, Approach, and Research Method: Argues case for indexing
over alternative investment vehicles, most especially against active management.
Summary of Key Findings or Insights
Argues for buying and holding of a broad-based index market fund.
After calculating expenses, active management is a negative sum game. pg XV
Investment return is inversely proportional to the level of investment services
contracted and frequency of trades pg 6 & pg 36, 44
Attempting to beat the market is a loser’s game.
Stock market returns are based on
Investment return: earnings growth and dividend yields AKA intrinsic value pg
192
Speculative return: change of P/E ratio pg 14
In the long run, speculations washes out pg 192
Investment return, over speculative return, is the basis for stock market returns. pg
18-9
Cap-weighted index, the index mode of choice, automatically adjusts to stock
price, thus never having to buy and sell securities, avoiding transaction fees and
tax consequences.
S&P 500 has .98 correlation to the total stock market index. pg 28
Investor’s pay too little attention to costs. pg 40
Compounded costs take a bit chunk out of one’s investments. pg 43
Dollar-weighted returns are a good measure of performance chasing. pg 50
Wall street is eager to aggressively market and offer the newest investing fads. pg
58
Like Stanyer, argues that speculative returns have artificially drummed up stock
prices.
As this rights itself in the future, along with the combination of smaller dividends,
subdued stock returns are imminent. pg 70
Chances are slim to pick a mutual fund that beats the market after fees, especially
over long time horizons. pg 81
Mutual funds suggested by advisors underperform relative those picked by
investors themselves. pg 104
Investment advice works best on a fee-only basis. pg 112
Index funds can vary in expense ratios significantly. pg 127
Market timing has made for low dollar-weight returns in small-cap and value
index funds. pg 134
Foundations can suffer management costs as high as 3 percent. pg137
Fundamental index investment products are active management manifestations.
ETFs, that are not low cost and are not held for eternity, fail to produce the
benefits of an index fund. pg 165
Jon Luskin - MBA Thesis v4.docx Page 75
Diversification eliminates risk from security selection, leaving only market risk.
pg 193
Mutual funds have a conflict of interest where board members are not investors.
pg 195
Mutual fund managers chase asset size for fees, not pursue performance. pg 195
Argues against commodity funds, which are now in a bubble. pg 203
Funds of funds layer another fees on top of the already-high fee hurdles of hedge
funds. pg 204
Suggests bond laddering via index funds. pg 207
Tilting a portfolio towards small or value risks lower return relative the market.
pg 206
Weaknesses and Limitations
Gives much more elaboration on his argument for index stocks than he does bond
funds.
Argument for subdued market returns is a very interesting argument, and a slight
departure from the topic of his book. Could do well to more greatly elaborate on
this as well.
Suggests municipal bonds, but his argument for it is very short. Especially relative
Swensen’s argument against munis. Pg 200.
Study of Endowments
National Association of College and University Business Officers and Commonfund
Institute, January 2011
Type of Work: Statistical survey
About the Author(s): National Association of College and University Business Officers
and Commonfund Institute.
Summary of the Scope, Approach, and Research Method: Analysis of investment
management and governance practices at 850 higher education institutions via web-based
questionnaires and field interviews.
Summary of Key Findings or Insights
Institutions are deeply committed to the Yale model – allocating more than the
majority (52%) of their holdings to alternative asset classes.
Larger institutions, with a greater percentage of allocation to alternatives, paid the
most in management fees 1.00%, versus an average of 0.66% and a median of
0.52%.
Larger endowments posted the highest returns, because of their ability to diversify
more greatly and the ability to pay top talent.
Institutions employ an average 1.5 FTE investment managers.
The opposite was the case last year, as smaller endowments, invested in more
traditionally assets, posted smaller losses.
Large endowments have more exposure to alternatives and less to fixed income
and domestic equity. Vice versa for small institutions.
Argues that aggressive allocation to alternatives is the way of the future.
Institutions with traditional (conservative) holdings made the biggest gains
(smallest loses) last FY was just a fluke, so says the study.
Jon Luskin - MBA Thesis v4.docx Page 76
Institutions are allocating a larger percent of their positions to alternatives at the
expense of domestic equities over the last ten years. Larger institutions have
alternative/less domestic & fixed income holdings that smaller institutions.
Three quarters of domestic equity positions are actively managed.
Larger institutions rebalanced more frequently.
Rebalancing took place at either calendar based intervals (monthly, quarterly,
semi-annually) or when an asset class fell out of range.
Smaller institutions were less diversified in the alternative asset allocations, with
allocation mostly going to hedge funds.
1/3 of endowments are now making considerations for liquidity in constructing
their portfolios, the percentage is greater for larger endowments. The smallest
endowments have the most liquid portfolios.
The largest institutions were ten times as likely to pay additional fees for superior
performance of fund managers relative smaller institutions.
Smallest institutions had the highest percentage of assets underwater, with the
largest institutions the smallest percentage.
Smallest institutions had 1/20
th
the amount of staff devoted to endowment
management that the largest institutions had
Other Comments
The 3/5/10 year returns put the 5% suggested spending into serious question.
It would be interesting to compare Yale’s endowment returns of the same FY to
the average – real estate especially. This will speak to the value/talent of the Yale
staff.
With a larger endowment, organizations have the option to put more assets into
risker (alternative) assets, with the potential for greater growth. The greater
growth gives greater returns, hence the larger spending rate.
Emphasizes at the conclusion of chapter 1 and 2 that aggressive allocation to
alternative strategies is the way to go.
With more resources, larger institutions are able to do more, to be the better
investor.
Guest Lecture by David Swensen
David Swensen, Nov 19, 2008
Type of Work: Recorded video presentation
About the Author(s): Chief Investment Officer of the Yale Endowment
Summary of the Scope, Approach, and Research Method: Case study
Summary of Key Findings or Insights
Asset allocation is the overwhelming determinant of investment results, followed
by market timing and security selection.
Asset allocation explains more than 100% of returns because the other modes,
mentioned above, require costs in the form of trading fees, consultants, etc.
Investment in small cap stocks show the greatest returns.
Time-weighted returns are misleading – dollar-weighted returns, which calculate
the buy in and close out time, show losses for investors across the board. Time-
Jon Luskin - MBA Thesis v4.docx Page 77
weighted returns time the market (mutual funds) improperly – buying high and
selling low.
Marketing timing, spurned by greed and fear, is to be avoided as an investing
tactic.
Security selection is a negative sum game, when fees are included.
“Survivorship bias” skews performance results of mutual funds because those
mutual funds that fail/ no longer exist are not included in the calculation.
Backfill bias operates in a similar fashion, skewing real performance, producing
better looking numbers.
Active managers in alternative asset classes have a much wider range of
performance spreads relative traditional asset classes. Thus, alternative asset
classes are much less efficiently priced.
Swenson argues for an equity-biased portfolio that shuns market timing.
Argues that the large degree of diversification into alternatives lowers the
portfolios entire risk, because the assets have low correlation.
Swenson argues for either full active management or total passive management.
When an effort is made to put partially active manage a fund, the result is failing
to match the market. He says it’s incredibly tough to beat the market. Suggests
index funds for those do not have the resources to acquire top active management.
Unconventional Success
David F. Swensen, 2005
Type of Work: Scholarly synthesis
About the Author(s): Chief Investment Officer at Yale University, who set
unprecedented investment returns and modern model for institutional investing with his
allocation to alternative assets.
Summary of the Scope, Approach, and Research Method: Argues for his asset
allocation model, referencing other studies to make his point.
Summary of Key Findings or Insights
Argues for diversification and an equity bias.
Argues against anything other U.S. backed bonds for the fixed income positions
of a portfolio.
Argues for over allocation to asset classes where the individual investor has
superior skill in security selection. However, for most people, they do not possess
such a skill set.
Explains that even the highest-rated corporate bond has nowhere to go in value
but down. This is contrary to stocks which fluctuate in value.
Callability of corporate bonds allows the corporate bond issuer to call the bond if
interest rates drop. The investor cannot exercise any such option if interest rates
rise.
On a best case scenario, corporate bonds can pay their coupons and return
principal expected. In a worst case scenario, the investor loses everything. This is
in contrast to equities that have unlimited upside and the finite downside of
company going out of business.
Bond holders suffer at the gain of stock holders of the same company, executing a
call on bond to take advantage of more favorable rates is an example of this.
Jon Luskin - MBA Thesis v4.docx Page 78
Asymmetric information and call options benefit sellers and issuers of tax-
exempt/municipal bonds respectively over buyers.
The model of hedge fund fees has investor sharing profits with fund managers
while absorbing all loses themselves.
Ventura capital needs upper decile active management to post returns consistent
with its level of management fees, risk and illiquidity. Otherwise, investing in the
broad market posts greater returns for less risk.
Venture capital firms charges high fees and fail to compensate investors for the
high level of risk. Only those firms with the top 10 or 25% of performance merit
consideration for investment. None of the top venture management firms are
currently accepting new donors.
When investors chase performance of hot mutual funds or stocks, only those with
recent strong growth, they are usually bound to end up buying high and selling
low. Internet mutual funds are an example of this. Investment losses are
compounded by management fees regardless of performance, and unfavorable tax
treatment of gains relative losses.
Mutual funds have a variety of methods to spin their performance numbers,
masking poor performance.
The tendency for investors to chase performers is further increased by
Morningstar, a rating system that puts most of its emphasis on past results.
Active rebalancing affords investors the opportunity to sell high and buy low.
Yale added 1.3% return to its endowment in 2003 via rebalancing.
With its nearly guaranteed rate of return over actively managed mutual funds and
its favorable tax treatment, Swensen argues for passively managed index funds.
A mix of 83% S&P 500 w/ 17% MSCI EAFE has the least volatility of either
combination of those two assets.
Mutual fund companies give brokers a fee for selling that fund company’s funds.
Roughly ninety percent of 401K companies practice pay to pay, limiting investor
access to more cost effective mutual funds, like Vanguard
ETFs indexes are most tax-efficient mutual fund indexes, in part due to arbitrage
related to change in net asset value.
Weaknesses and Limitations
Fails to mention some of the more other options open to investors – like
commodities, international REIT. These offer an additional level of
diversification.
Fails to properly discuss time horizons. Should all investors follow the time
strategy if one has a 3 year investment timetable and other 30 years?
Written before 2009, when assets showed to be much more highly correlated than
once thought.
Needs greater detail regarding how to allocate different time horizons and other
liabilities/existing holdings, but only provides brief rules of thumb.
Swenson discusses equity allocation in chapter 4, but did not mention how they
intermingle with bond holdings. Given his suggestion at the beginning of the book
regarding asset class allocation, the chapter’s lack of reference does not make
sense.
Jon Luskin - MBA Thesis v4.docx Page 79
Makes no effort to distinguish between taxable and tax-deferred accounts.
Makes large efforts throughout the book to push index, but then changes course
towards the ends of the book, giving ideas on how to select individual stocks.
Does not address the place of bond funds, especially high yield funds in the
function of diversifying risk
Other Comments
Swensen touts Vanguard as providing the lowest fees, and therefore the best values for
investors. Already dated, exchanged traded funds offer even lower fees. Charles Schwab
currently has even cheaper offerings than Vanguard.
2012; The Yale Endowment
Yale Investment Office, 2012
Type of Work: Endowment Report
About the Author(s): Chief Investment Officer at Yale University since 1985
Summary of Key Findings or Insights
Yale’s portfolio’s get progressively heavier into alternatives each year.
Surpassed all industry benchmarks, both the market other endowment portfolios
In its reporting, separated real estate from natural resources, breaking up the
single category of real assets. This gives the portfolio a hair more transparency.
With positions in real estate, an endowment receives protection against inflation,
with property values fluctuating with market supply and demand.
With positions in real assets, an endowment receives protection against inflation –
as the price of real assets rise, so too does the value of the Yale endowment. As
Yale must purchase some of these assets – for the purposes of heating,
construction, etc. – the institution is buffered.
The endowment contains “thousands of funds.” This really speaks to Swenson as
a “manager of [fund] managers.”
Endowment provided $987 in funds for FY 2011. This increased by over $100
million last year.
Yale endowment allocates assets on the basis of mean variance, diversifying the
holdings based on risk weights for each asset allocated.
Yale expects long term returns of 6.3% per annum with the current allocation.
Argues that nontraditional asset classes have greater potential for returns, and
make for greater diversification. Claims that current allocation, with only a small
sum allotted to domestic equities, the rest in alternative asset classes, is less
volatile than the previous portfolio that held a majority in domestic equity
positions.
Jon Luskin - MBA Thesis v4.docx Page 80
Claims alternatives as “less efficiently priced” than conventional equities, giving
the opportunities to exploit these opportunities for profits via active management.
Yale’s spending rule aims to provide income and protect the “real” fund’s value.
Spending rule aims to mitigate the market fluctuations/value of the endowment.
Weaknesses and Limitations
States the need to keep up with inflation, thus the funds be invested in more
aggressive holdings. This seems counter to conventional logic. If one needs the
money very badly, why put it at such great risk?
Other Comments [optional]
Given the current increasing rate of allocation to alternatives, at which point the
portfolio will be fully alternatives?
Is it really possible that Swenson manages “thousands” of funds?
Nonprofit Guide to Prudent Investing
The Merrill Lynch Center for Philanthropy & Nonprofit Management, 2009
Type of Work: How-To Guide
About the Author(s): Merrill Lynch, owned by Bank of America, is financial services
company. The company serves “clients in more than 150 countries with operations based
in 40 countries, providing services ranging from investment and corporate banking to
investing and equity execution services.” (Bank of America n.d.)
Summary of the Scope, Approach, and Research Method: This piece is an
introduction for trustees on investing a non-profit organization’s assets. It gives basic,
practical advice, written for those initially looking at investing.
Summary of Key Findings or Insights
In decades past, fiduciaries were held accountable for each individual investment
made by a non-profit organization, skewing investments toward “safe” assets.
With passage of various legislature, portfolios are now examined in their entirety,
allowing for a more balanced approach to investing. All of these acts share the
goal of eliminating outmoded concepts of charitable investment in favor of
Modern Portfolio Theory (MPT).
o The Uniform Management of Institutional Funds Act (1972) gave the
board authority to outsource investment management, requiring the board
to monitor investment manager’s performance on a regular basis. Also
enabled fund managers to use modern investment techniques, such as
total-return investing, a tenant of Modern Portfolio Theory (MPT).
o Restatement of the Law of Trusts 3d: Prudent Investor Rule (1992) holds
trustees liable for improper conduct as measured by reference to the total
portfolio return that should reasonably have been expected from an
appropriate investment program in light of the purpose(s) of the trust or
portfolio. Investments must be judged in relation to the total portfolio, not
in isolation. Risk versus return is the fiduciary’s central consideration.
o The Uniform Prudent Investor Act (1995) requires trustees of charitable
trusts to use modern investment practices.
Jon Luskin - MBA Thesis v4.docx Page 81
o The Uniform Prudent Management of Institutional Funds Act (2006) gives
the board more flexibility in making endowment expenditure decisions so
that the board can cope with fluctuations in the value of the endowment. It
provides modern guidance for the prudence standards fiduciaries should
follow in making investment decisions.
When investing, consider the following risks:
o Individual investment risk is devaluation of a security below the initial
purchase price; AKA specific risk.
o Market risk is the devaluation of all securities as a symptom of total
market devaluation. i.e. correction or recession.
o Inflation risk is the loss of purchasing power of assets.
o Liquidity risk is inability to sell an asset due to a lack of buyers.
o Interest-rate risk is the change in interest rates that will lower an asset’s
value. i.e. bonds.
o Currency risk is devaluation of a foreign asset when the dollar rises
relative that country’s currency.
Modern Portfolio Theory:
o All assets do not equally or simultaneously lose, or gain, value.
Diversification performs best when different asset have low
(uncorrelated) or opposite (inverse) performance with each other.
o The appropriate mix of assets can ensure greater portfolio returns over
time, irrespective market fluctuations.
Diversification can be achieved by not only asset classes, but also
within the asset classes.
o The riskier the asset, the greater the potential return.
o Success in an investment strategy is how assets are divided among the
various asset classes (stocks, bonds and cash, for example).
Different monies (operating reserves, retirement plan assets, capital campaign
reserves, etc.) need to be invested differently, relative timeline for withdrawal,
investment goals and risk parameters. Board communicates the requirements for
growth, income and liquidity needs; time requirements of each monies invested to
fund manager.
Timetables for withdrawal determine acceptable levels of risk, and thus the assets
that will be invested into.
o operating reserves: “very short time frame, “ wherein the objective is to
preserve capital and maintain liquidity. This means investing in interest-
bearing checking accounts and money market funds, etc.
o Capital campaign funds: with a longer timeline, medium-term fixed
income investments are an option.
Boards should have an investment policy that:
o Defines general objectives.
reasons for establishing the policy and the fund portfolio’s purpose
and size.
create terms of return requirements, risk tolerance, time horizon
and liquidity.
Jon Luskin - MBA Thesis v4.docx Page 82
return requirements depend on the purpose of the fund and
timeline for withdrawal
set return goals for each asset class and each fund’s total
return.
o Delegates investment management to a financial committee or
professional manager(s)
o Sets asset allocation parameters
determines percentage of assets for investment class
consider timeline for withdrawal, rate of return, liquidity
and risk
o investment manager can deliberate on the above
set diversification guidelines to limit the limit exposure to
any particular sector (Energy, Information Technology,
etc.) or company
sets protocols for rebalancing portfolio of investments
when those original percentages change over time
o Describes asset quality
Determines investments that meet investment objectives
determines exposure to various securities, economic
sectors, countries, cash holdings, etc.
o restricts investments based on quality ratings of
independent third parties. i.e. Standard & Poor’s or
Moody’s.
o Provides for regular policy review
o Sets guidelines for hiring and firing fund managers
o Provides appropriate guidance without hindering a fund manager’s ability
to perform their job
Period reports by the fund manager reports detail transactions, demonstrating
meeting investment goals, detail asset class breakdown, declaring realized and
unrealized gains and annualized income and yield.
Weaknesses and Limitations
This piece uses a broad brush with a short stroke, briefly detailing responsibilities
and recommendations for investing. The piece does not describe the numerous
principles in depth. While the “how to” portion is satisfactory, the opening
portion, defining laws, is lacking. The portion of the guide could offer greater
elaboration. Total material could be equal if more time was put into legal
requirements, and less material put into practiced solution.
While by no means comprehensive, the article is good starting point for the
subject. The article itself is less a guide as it is a promotional piece for Merrill
Lynch’s financial services. As it a promotional piece, the document substitutes
complex processes for simpler ones. As mentioned, there is opportunity for
elaboration, but in order to retain the audience, the author has kept it simple and
brief. This serves to hold the reader’s attention, but makes it less valuable for
those looking for more complex content.
Jon Luskin - MBA Thesis v4.docx Page 83
Once upon a time…: A historical overview of the development of asset allocation for
nonprofit organizations
Don Ezra, September 2012
Type of Work: Case Study
About the Author(s): Don Ezra is Co-Chairman of Global Consulting and Director of
Investment Strategy at Russell Investments, which has $152 billion in assets under
management, and creator of the Russell Global Indexes, including the Russell 2000®
Index.
Summary of the Scope, Approach, and Research Method: Reviews the history of
advents in analyzing risk/return in investing, including models and for analysis and
portfolio compositions.
Summary of Key Findings or Insights
Diversification can reduce risk. Risk and covariance are the foundations of
Modern Portfolio Theory.
While more precise definitions of assets classes may vary, there is common
consensus on the distinctions of equities, bonds and cash equivalents.
Uniform Prudent Management of Institutional Funds Act recommended that total
returns be the investment goal.
“The early days of asset allocation” results in a 60/40 split of equities to bonds.
Early studies on risk/return where inherently flawed in their variables.
Illiquid, infrequently traded, assets returns are based on subjective estimates.
Early theoretical formulas technically favored holding these assets.
One mode to portfolio composition begins with selecting “broad, liquid asset
classes,” then adding “some” illiquid, more volatile assets.
The author feels that amongst all these models, the greatest challenge is
evaluating an investor’s risk tolerance.
Yale Chief Investment Officer, David Swensen changed the traditional portfolio
to model that put a “heavy reliance on private equity and other so-called
alternative asset classes, and an inclination to passive (and much smaller)
exposure to traditional asset classes.
Classic financial analysis tools failed to accurately predict extreme market
conditions – like the financial crisis of 2008.
Multiple asset classes can all be affected by the same return drivers. Sophisticated
investors now focus on risk management, and a portfolio’s exposure to return
drivers, not just asset classes.
Weaknesses and Limitations
The technical aspect of this paper can make it unintelligible without simultaneous
research/previous knowledge on the subject.
This biggest short coming of this paper, however, is failing to elaborate on what is
now the standard for investing: the model set by Yale Chief Investment Officer
David Swensen.
Other Comments
This is a moderately technical paper. Previous experience or knowledge in
investing is required to understand some of the principles mentioned here.
Jon Luskin - MBA Thesis v4.docx Page 84
Principles of Nonprofit Investment Management: The key issues facing trustees and
financial officers’s
Common Fund Institute, 2006
Type of Work: How-To Guide
About the Author(s): Commonfund Institute works to advance “investment knowledge
and the promotion of best financial management practices among nonprofit
organizations.” Commonfund serves charities, educational institutions, foundations, and
health care institutions.
Summary of the Scope, Approach, and Research Method: Billed as a summary of a
“comprehensive approach to nonprofit investment management.”
Summary of Key Findings or Insights
Investment committee defines investment objectives with respect to the
nonprofit’s philanthropic mission in the form of an investment policy statement
(IPS), guiding investment decisions. Policy statement should be jargon-free,
reviewed annually, and may cover such issues as:
How to select an investment manager and how to manage the investments
How investments will contribute to the organization
Desired total return from investments
Expected donations
legal stipulations
Percent of endowment to be spent vs. re-invested
liquidity of assets to meet organization’s needs
level of tolerable risks for the fund’s monies, and those assets deemed not invest-
worthy
decision making processes for investment decisions
Investment expertise can be obtained by hiring an outside professional.
Timelines for distribution determines investment management’s actions.
UMIFA: there is no specificity as to what the payout percentage should be;
governing board decides.
Fund exists to fund organization programming via growth, dividend payout, etc.
Goal is to grow fund concurrent to the rate of cost increases the organization
faces.
Traditionally, “5 percent of a three-year moving average of market value” has
been the pay out from funds. Recent market volatility now makes this mode
ineffective, causing some foundations to up fund’s consumption rate 6% in order
to fulfill previous commitments.
Cash payments, dividends and interest alone fail to match economic growth. As
such, equity fund positions themselves must be sold off.
The average life of foundation’s endowment is a decade and a half. Foundations
on longer timelines will require cash infusions, smaller payouts and more
aggressive investing.
“Allocation of the portfolio among the principal asset classes is the committee’s
most crucial investment strategy decision.”
Organizations that require a high volume of liquidation of assets on short notice,
like the Red Cross, should choose an arguably less-risky, fixed income-centric
Jon Luskin - MBA Thesis v4.docx Page 85
portfolio. Over a long-enough timeline, such a portfolio equates to a smaller
returns relative a portfolio with an equity bias.
UMIFA in 1972 broadened the “prudent man rule” into a “prudent investor rule,”
permitting fiduciaries to consider the expected total return (i.e., capital
appreciation as well as income). Most nonprofits now use this approach.
Modern portfolio theory balances the risks of various kinds of investments against
one another.
investment risk is measured in volatility, called the “standard deviation,” a
percentage of the investment’s value changes.
Offset an asset’s volatility by holding other assets with low degree of correlation.
Combining risky assets within a single portfolio can lower the overall volatility of
the portfolio.
Proper asset allocation determines successful returns.
Diversification among and within asset classes can further lower a portfolio’s
volatility.
Organizations are moving from fixed income assets into equities and alternatives
Alternatives: hedge funds, private equity, venture capital, equity real estate,
distressed debt strategies, commodities, and energy and natural resources.
alternatives tend to have a reduced correlation to traditional investments
manager performance should be monitored on a continuing basis
Investment committee hires an array of investment managers to execute the
intentions of the board’s investment policy.
nonprofits often outsource the entire selection process
number of managers used increases with fund size
Managers should now be given the freedom to maximize investment opportunity
as they know best.
A strategy for investment firms is to create a fund around a particular manager,
using buying power to lower fees, making manager available to smaller investors
– just like a mutual fund.
Monitoring fees is critical, as managed funds can fail to meet the market average.
Weaknesses and Limitations
Commonfund’s model predictions suffer in their accuracy from what Ezra
discusses: fat tails. In extreme market fluctuations, such we that have experienced
in recent times (sub-prime crisis), the possibility of great loss is greater.
This article, similar to the one by Merrill Lynch, is one part educational, one part
advertisement. Commonfund discloses that they are in the business of placing
fund managers with nonprofit organizations seeking to invest their cash assets. As
such, the piece is written for the board member, not the fund manager. Language
is simple, to keep reader attention, forgoing the more complex financial
instruments.
Could do more to elaborate on a risk manager’s role, duties, challenges, etc.
Other Comments
Jon Luskin - MBA Thesis v4.docx Page 86
This simply written, non-technical piece is meant specifically for board members.
No previous knowledge of financial instruments is needed to comprehend the
article.
Says “For nonprofits, this decision must embody the philanthropic mission and
perhaps deeply held feelings of founders and members of governing boards…”
One can infer that this means that the companies invested in be in line the NPOs
values. For example, the Sierra Club may not find itself putting its endowment
funds into shares of ExxonMobil.
This will, it can be argued, a affect portfolio’s rate of return. Exxon Mobil, a top
equity that pays a dividend, can be a lucrative investment, most especially in
coming years as oil conglomerates continue to merge, setting prices (and profits)
to the highest degree that the market will bear it.
Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in
the Shadow Banking System; A Study of Six New England Schools,
Joshua Humphreys, May 27, 2010
Type of Work: Statistical study
About the Author(s): “Joshua Humphreys is a fellow at Tellus Institute. An historian of
the social problems of capitalism, Humphreys has become a leading advocate for more
sustainable and transparent forms of finance in today's exceedingly complex capital
markets.” (Tellus Institute 2012)
Summary of the Scope, Approach, and Research Method: Examines returns and
affected communities of six Ivy-league endowments
Summary of Key Findings or Insights
Endowments sought growth and total return at the price of consistent/reliable
income, liquidity & volatility.
Endowments sought risky investments, like emerging markets, made possible for
by long time horizon.
Swenson turned Yale’s traditionally modeled portfolio of stocks and bonds into a
portfolio heavily invested in alternatives.
The effect of leveraging multiplied investment losses.
Conflicts of interest arise when board members in the financial sector recommend
their firm to management an institution’s investments.
This is problematic when those board members specialize in alternative
investments – those investments that carry greater risk.
The implementation of a Chief Investment Officer position has skewed
investments into risker assets.
The loss of value in investment positions has caused funding cuts within the
institutions, manifesting in a detrimental effect on the economy of the college’s
local communities.
Investment managers can trade positions more frequently, not penalized by the tax
consequences – as the universities are tax-exempt.
Universities issued public bonds to pay operating expenses, allowing them to keep
their cash invested in risky assets, generating high returns. This is not quite
technically illegal, but costs tax payers millions annually. Humphreys describes
this as ‘indirect arbitrage.’
Jon Luskin - MBA Thesis v4.docx Page 87
Some schools are financing debt as high as 75% of total assets.
Humphreys suggests that endowments pursue higher liquidity/lower volatility
investments, setting aside a portion of funds in good years for utilization in bad
years.
With regard to those highly-risky/illiquid assets, Humphrey critiques that risk
must be measured beyond just portfolio return. Instead, he suggests the measure
be the consequences of smaller endowment payouts. The consequence from a
down markets in the form of layoffs, and stalled projects, etc. must be measured
when calculating the volatility of assets, argues Humphreys.
Overtime, endowments have moved from mortgages and real estate into
government bonds, into a split of bonds and equities and then onto the endowment
model; moving from pursuing income, to growth, and then onto total return.
Endowment’s entering into previously un-entered markets created greater risk,
risk that was attempted to mitigate by diversification. In an attempt to lower entire
portfolio’s risk by diversifying into other asset classes (i.e. commodities), risk was
actually increased. This is because the commodities market was effectively now
more risky than previously. The infusion of the endowment’s capital was the
cause for this risk – the drive up in prices had essentially created a bubble.
By endowments investing heavily into alternatives, it lends credibility to these
dubious asset classes. Imitators (pension funds) arise, overcrowding the market.
When universities attempted to sell assets from those small, overcrowded
markets, prices dove due to the unusually high number of sellers.
Despite the financial crisis, endowments have allocated even more aggressively
into alternative assets.
Of the six endowments studied, that with the highest proportion of liquid assets
(Boston College) suffered the smallest decline in value, 5% less than average.
CIO positions are seeing high turnover as CIOs leave to start their own firms,
usually hedge funds. This is despite the million dollar salaries that investment
staff have been paid.
By pursuing speculative investments, the endowment model no longer performs
its original function: stable income for operational expenses.
Weaknesses and Limitations
Humphreys notes the decline in value of endowment assets from the recent
financial crisis, inferring that such losses could have been avoided where those
assets invested in less risky positions.
Yet, he does not provide substantial comparisons in his critique. For example, a
more thorough paper could write, “The endowment model showed portfolio
declines in X value. A mode modestly allocated portfolio of the 60% stocks and
40% bonds would have declined only Y percent.” He cites the NCSE, which notes
a higher return of 3.7% during the financial crisis. Considering that the market at
one point literally halved its value, 3.7% below a more conservative approach in a
single down year is arguably insignificant given the gains produced by some of
the more aggressively-allocated portfolio.
Makes the claim that commodities become more volatile once endowments dump
their money into it, but gives no data to prove it.
Jon Luskin - MBA Thesis v4.docx Page 88
Could elaborate on how daily trading to take advantage of market volatility spurs
market volatility. Common sense dictates that buying a position when it is low,
increases demand, thus driving up the price, thus restoring the original market
price.
Though Humphreys does invest considerable time in discussing pay inequity, it is
still difficult to discern what pay inequities, though an important issue, has to do
the failure of the endowment model
Yes, lower pay outs from an endowment mean lay-offs. But does the endowment
perform any differently than conventionally held positions? Humphrey seems to
ignore the fact that a down market means a down market. That means less money
in all kinds of investments, not just the aggressive/alternative ones.
Other Comments
Mentions that social inequity is increased by the current system, with universities
executives increasingly compensated, while others are laid off in down markets. It
seems inappropriate, the subject of another paper entirely.
Humphrey’s analysis is sort of a catchall. There seem to be many subjects in the
paper that could be the subject of an entire paper. There are numerous
opportunities to delve more deeply into the content mentioned, but for the sake of
brevity, it is not. For example, conflicts of interest alone could be more
thoroughly discussed – with trustees at the universities managing the respective
endowment’s funds with their respective financial institution: Morgan Stanly, etc.
Investment Policy Statement template
supplied by Steven Vielhaber, retired investment banker at Commonfund
Summary of the Scope, Approach, and Research Method: Platform for delineating the
necessary details for an investment policy statement
Summary of Key Findings or Insights
Sample allocations include no suggestions for alternative investments
IPS serves to:
Set terms for the investment of the organizations’ funds
Determine how the money is invested (asset allocation, diversification, etc.)
Ensure assets are invested within levels of tolerable risk
Establish communication and evaluation criteria
Ensure legality of investment initiatives
IPS creates objectives for the investments
Determine on what basis to draw funds from the endowment
Moving average
Annual percentage increase
as needed, as determined by the board
To ensure that asset allocation ensures positive returns (total returns) while still
providing proper liquidity for spending needs
Manage costs of investment services
IPS establishes time horizon and cash (liquidity) requirements
IPS establishes risk tolerances based on
Level/rate of future contributions to the organization/endowment
Jon Luskin - MBA Thesis v4.docx Page 89
The subjective “strength” of donor base
IPS sets a targeted rate of return.
Withdrawals/new investment purchases will function to bring the portfolio into
balance over time. Only with the board’s permission will certain assets be
sold/bought to re-allocate the portfolio in the absence of the above.
IPS defines restricted investment practices, such as investing in too new a
company, or the use of trading on margin.
IPS defines requirements for diversification. For example, not holding/allocating
more than 10% of a portfolio to a single company
Defines requirements for
investments in bonds, as in the minimum level permissible credit rating, and
maximum amount of holdings of certain credit ratings.
high yield bond holdings, including credit ratings and diversification
requirements.
international holding, restricting percentages of exposure to companies, sectors
and countries. Allows currency hedging, but not speculation.
Allows for currency futures contracts with limited applications.
Defines
fund manager selection, which includes consideration of a manager’s past
performance.
liquidity needs for all holding, including mutual funds.
Notes annual evaluation, giving performance comparisons for benchmarks: S&P
500, etc. Deems mutual fund performance evaluation at least quarterly.
Sets “Review and Analysis” mandates or fund manager and change
‘considerations’ should a fund manager/mutual fall below a certain performance
thresholds.
Weaknesses and Limitations
It is difficult to understand the distinction between “To maintain the purchasing
power of the current assets and all future contributions” and “Maintain a constant
funding-support ratio.” Both speak to cost increase, but the difference is not clear.
Does not specify the limits at which a fund manager can be compensated.
Other Comments
One of the objectives states “To maximize return within reasonable and prudent
levels of risk.” The statement almost seems counter-intuitive. To maximize return
is to take risks.
The layout restricts the much more aggressive practices of what has been called
the Endowment model: short selling, hedge funds, use of leverage, etc.
Investment Policy for XYZ Institution
sample submitted by Steven Vielhaber
About the Author(s): Steven Vielhaber, investment professional, former Commonfund
staffer
Summary of the Scope, Approach, and Research Method: Sample investment policy
statement
Summary of Key Findings or Insights
Jon Luskin - MBA Thesis v4.docx Page 90
Like the IPS above,
o suggests quarterly review
o sets diversification guidelines for cash equivalents
Unlike the previous IPS above
o this one lists alternative assets in the allocation section.
o suggests taking advantage of market fluctuations to rebalance the portfolio
as appropriate
o discusses an investment committee, a good suggestion, as deliberating on
much of this subject matter could be time consuming for the board proper
in its entirety
Also sets standards for domestic equity screening and diversification, though not
as precise as the above IPS
While this IPS did provide guidance, it provided much less guidance than the
sample above. Thus, a fund manager would have more freedom in his investment
decisions. There are benefits and disadvantages to both scenarios.
Both pieces use indexes as performance as well as peer performance when
evaluating their fund manager
Weaknesses and Limitations
The policy seems to contradict itself, initially looking to retain purchasing capital,
but later stating the focus of total returns.
Given very specific instructions on quarterly reports as composed by the
investment manager.
The reading’s author, title, and publication date
Investment Policy Statement, supplied by Steven Vielhaber
See above two examples
Summary of Key Findings or Insights
Set income as a secondary objective over preservation/growth of capital
Using index benchmarks as a performance metric is standard in all pieces
reviewed
Suggests annual review of IPS
Weaknesses and Limitations
Due to its brevity, gives much guidance than previous pieces
The Investment Policy Statement
John S. Griswold and William F. Jarvis, 2011
Type of Work: How-To Guide
About the Author(s): John S. Griswold, Executive Director, Commonfund Institute
William F. Jarvis, Managing Director, Commonfund Institute
Summary of Key Findings or Insights
Suggests annual review of IPS
IPS should proclaim
purpose/role of endowment in supporting the organization
time horizon of funds, withdrawal rate, reinvest rate of gains realized
who manages the funds and how that manager is selected and evaluated
Return on investment (ROI)
Jon Luskin - MBA Thesis v4.docx Page 91
Investment guidelines (strategy, diversification, approved assets, Liquidity
requirements Etc.)
relative agreed upon permissible risk
Payout rate (monthly, annual, bi-annual) will determine asset allocation
Uniform Prudent Management of Institutional Funds Act (UPMIFA) dictates that
unless otherwise declared by the donors, maintenance of purchasing power is a
priority for funds invested –as opposed to a finite endowment timeline
Investment committee can be composed of non-trustees. Research shows that at
least two to three, of an average of 6 to 8, committee members are investment
professionals.
Between 25 to 33 percent of investment managers are outsourced.
Financial modeling using long-term simulation tools can visualize various
outcomes of different portfolios.
Suggests outlining certain asset classes that may not yet have place in the current
portfolio, so as to better educate trustees as to the various asset class distinctions.
Tolerances for risk need to be quantified by probing trustees.
Financial crisis left those using the endowment/Yale model short on cash, with a
majority of highly illiquid assets in their portfolio. Studies show that Institutions
are now holding larger-than-previous cash allocations: between 5 and 9 percent.
IPS needs to declare intention/duration (life AKA time horizon) of the fund.
Risk, not return, should be the center piece of IPS debate. Once a tolerable level
of risk can be agreed upon, returns can then be determined – not vice versa. From
this idea comes the Risk-based IPS. Its counterpart is the traditional IPS.
Set alternatives at a maximum of 25% of portfolio.
Weaknesses and Limitations
Did not speak to value or relevance of rebalancing a portfolio at pre-specified
times over when the portfolio gets out of balance. Also, did not elaborate on why
moving to rebalance on market timing is perilous.
Could elaborate further on asset class selection
Says that 9 percent is the targeted growth rate to retain purchasing power – this is
unrealistic for a portfolio over a long enough timeline, especially if that portfolio
includes a portion of bonds instead of equities. A more sustainable model would
make for smaller draw rate from the endowment – less than 5% annually – which
is not an option for private foundations. However, many endowments draw at
rates much higher than this.
Understanding the Managed Futures Strategy and its Role in an Institutional Policy
Portfolio
Commonfund Institute, October 2012
Type of Work: How To Guide/ Advertisement
About the Author(s): “Commonfund is an institutional investment firm serving
nonprofit institutions, pension funds and other leading institutional investors offering a
broad range of investment solutions in traditional and alternative strategies.”
Summary of the Scope, Approach, and Research Method: Touts benefits of portfolio
diversification with CTAs - Commodity Trading Advisors
Jon Luskin - MBA Thesis v4.docx Page 92
Summary of Key Findings or Insights
Over long periods of time, Managed Futures Funds, CTAs has low correlation to
market dynamics, showing positive returns in any market.
Composed of liquid assets.
Managed future funds are data driven, using empirical market metrics as a call to
buy/sell
They are driven by position fundamentals (price per earnings ratio, cash on hand,
etc.)
Managed future funds benefit most from greater market volatility, producing
losing returns in times of low volatility.
Weaknesses and Limitations
The technical complexity of this piece makes it hard to follow. This is especially bad
considering that this is an advertising piece for a product. Would someone want to
purchase something that they don’t understand?
Endowment for a Rainy Day, Winter 2010 & How Much Is Enough?
Burton A. Weisbrod & Evelyn D. Asch, February 22, 2010
Type of Work: Essay
About the Author(s): Weisbrod has written or edited 16 books and authored nearly 200
articles on the economics and public policy analysis of nonprofit organizations,
education, health, the causes and consequences of research and technological change in
health care, poverty, manpower, public interest law, the military draft, and benefit-cost
evaluation.
Summary of Key Findings or Insights
Nonprofits with large endowments slashed spending as their endowments
declined in value from the financial crisis.
Author sees this as contrary to the entire intention of endowments – as a source of
funds when other income streams are depleted, or costs expand.
Wealthier/larger endowments, have greater flexibility to invest in more volatile
investments, and thus generate greater returns. These more lucrative investments
are in alternative asset classes.
Authors argue that future generations will be wealthier than current generations.
Therefore, expenditures from existing endowment funds should be made today so
as to serve the current generation, who have less funds available to them then
future generations.
Argues that the endowment serves the organization, not vice versa. Money should
be taken from the endowment to serve the organization, not the other around – as
some organizations are doing: cutting spending and cancelling expansions plans
to preserve the endowment.
Organizations use endowment size/returns as an indicator of success/bragging
rights, luring in more endowment donors, instilling confidence in the
organization.
Argues for nonprofits to spend down endowments to keep up with operating
costs.
Weaknesses and Limitations
Jon Luskin - MBA Thesis v4.docx Page 93
Asks the important question, “How much is enough” but not does provide his
opinion on the answer.
Authors argue that future generations will be wealthier than current generations.
This is counter to the current trend of wealth distribution in the United States.
Good point that the whole purpose of the endowment is being changed.
Endowments function for the mission statement. It is not the mission that is
compromised for the sake of the perpetuity of the endowment.
Nonprofit Healthcare Organizations Report
Commonfund Institute, August 20, 2012
Type of Work: Statistical study
About the Author(s): “Provides fund management and investment advice for nonprofit
institutions.”
Summary of the Scope, Approach, and Research Method: “The design of the
Commonfund Benchmarks Studies of Healthcare Organizations took place in the winter
of 2011. Field interviews with the participating institutions followed in the first and
second calendar quarters of 2012.
Summary of Key Findings or Insights
Healthcare organizations are moving toward the endowment model, allocating a
greater percentage of assets to alternatives.
Greater allocation to fixed income than other organizations, in part to satiate
creditors.
Organizations with larger endowments had greater returns.
Portfolios with a smaller allocation to cash saw higher returns – thus it was a good
year on the stock market.
Number of investment managers is 1.6, on average, per fund.
The Curse of the Yale Model
Rick Ferri, 4/16/2012
Type of Work: Essay
About the Author(s): Contributing author to Forbes investment magazine. Covers low
cost index investing
Summary of the Scope, Approach, and Research Method: Comparison of NACUBO
findings versus benchmarks.
Summary of Key Findings or Insights
Posits that investment returns of copycat endowments fail because their
investment committee does not have the experience that the Yale investment
committee has – if these investment committees have any experience at all.
Argued that the best bet would be to have simply invested in low-cost index funds
instead of going with risky hedge funds, and their accompanying high
management fees.
Show how sample portfolio surpassed endowment returns.
Notes that one way hedge funds “beat the index” is by changing the index to their
liking.
Posits that schools lose and hedge fund managers win when under-skilled schools
pursue the Yale model.
Jon Luskin - MBA Thesis v4.docx Page 94
Weaknesses and Limitations
Does not discuss volatility of returns
Principles of Endowment Management; The seven key issues facing trustees and
financial officers
Commonfund Institute, 2001
Type of Work: How to guide
About the Author(s): “Provides fund management and investment advice for nonprofit
institutions.”
Summary of the Scope, Approach, and Research Method: Introductory piece for
investment committees
Summary of Key Findings or Insights
Endowments differ relative other investments in that the funds are invested
forever.
Endowments are governed by the UMIFA, Uniform management of investments
funds act
UMIFA lets investors consider total return over just income generation.
Endowments function to support the operating budget and provide a financial
reserve (in cases of emergency, expansion).
Board determines endowment purpose, creates IPS which is regularly reviewed.
IPS considers Role of the endowment in
supporting the organizations mission – short term (operating budget) vs. long term
(financial cushion/operating budget for future generations)
contributing to the balance sheet’s assets
rate of withdrawal, rate of re-investment from realized gains
investment strategy (asset allocation)
delegation of authority to fund managers, if any
increasing endowment withdrawal for the purposes supporting the operating
budget to keep pace with the rate of inflation risks the total endowment value in a
“bad year.”
smoothing rule to average payouts over five years
choose your return required and then choose assets (backwards from another
suggestion that proposes choosing level of acceptable risk first)
review allocation and rebalance annually
MPT, modern portfolio theory, which now guides investment decisions, argues
that higher risk of an asset provides higher return. Risk can be managed by
diversifying across assets classes, particularly those with low correlation to each
other.
Software can help determine possible returns relative various asset allocations.
Asset allocation is one of the primary responsibilities of boards/investment
committee.
Commonfund recommends outsourcing investment management – which is their
business.
Look at a potential manager for conflict of interest/connection to the board.
Jon Luskin - MBA Thesis v4.docx Page 95
Put expectations of investment officer, trustees and consultants in writing so that
each party knows and understands its obligations.
In order to preserve the value of the endowment, it must grow at a rate equal to
the spending rate, plus inflation, plus management fees.
John Bogle:
On average, active management fails to beat market benchmarks. With a large
enough pool, active management will beat the market. Thus, average active
management will perform below the market after management fees.
Use a board market index to contain costs.
Over time, international funds provide no superior value.
Consultants have a conflict of interest in recommending indexing funds because it
would mean a short term job for them.
Investment committee should meet regularly
Make asset class allocation targets and justify them
One argument that a conservative approach risks more than an aggressive one –
because of inflation.
The market has shown above average returns over the last few decades. Previous
to that, if an endowment used a 5% spending rate, total endowment value would
decline.
Diversification outside the traditional US stock and bonds may help to deal with
the problem above.
Spend less of endowments funds in good times so as to create more of a cushion
for bad times.
Valuation for assets is based on a single point in time – liquidating those assets, if
large enough, could distort their value.
Valuation can be made on a bid or ask price, each producing different values.
Weaknesses and Limitations
The shortest section of the paper is cost management. Perhaps this is because
Commonfund does not want potential (existing) customers analyzing their cost structure
too closely.
Can Timber Rebuild Harvard's Endowment?
Michael McDonald, September 20, 2012
Type of Work: News article on Harvard endowment
About the Author(s): Michael McDonald is a reporter for Bloomberg News.
Summary of the Scope, Approach, and Research Method: News article on Harvard
endowment
Summary of Key Findings or Insights
10% of Harvard’s endowment is in timberland
By the CIO of Harvard’s endowment’s own admission, other endowment’s don’t
have the resources she does to do the research into alternatives.
Harvard cashed out on certain timberland holdings three (of ten) years early,
because other endowments were driving up the price via increased demand.
Weaknesses and Limitations
Jon Luskin - MBA Thesis v4.docx Page 96
Short news article doesn’t offer in depth analysis.
Other Comments
It’s extremely interesting that Harvard sold it timberland holdings early. This speaks
EXACTLY to what Humprehys discuss in his piece – this overcrowding of a small
alternative market. This is driving up prices in this market precisely because endowments
are participating.
Asset Allocation and Portfolio Performance: Evidence from University Endowment
Funds
Keith C. Brown, Lorenzo Garlappi & Cristian Tiu, March 31, 2009
Type of Work: Statistical Study
About the Author(s): Keith C. Brown, CFA, University Distinguished Teaching
Professor & Fayez Sarofim Fellow, McCombs School of Business, Department of
Finance, The University of Texas at Austin
Lorenzo Garlappi, Associate Professor, TSX Venture Exchange Professorship in
Finance, Department of Finance, Sauder School of Business, University of British
Columbia
Cristian Tiu, Assistant Professor, Finance and Managerial Economics Department
Summary of the Scope, Approach, and Research Method
Statistical analysis of pension fund and mutual funds returns from mid 80’s to mid 2000s
using NACUBO data
Summary of Key Findings or Insights
Posits that security selection (active management), not asset allocation (including
asset allocation into alternatives), accounts for the returns of the largest
endowments.
Unsurprising, large endowment have a larger allocation to alternatives than small
endowments.
Calculations posit that asset allocation accounts for 75% of returns on average.
Security selection separates returns.
Active management, in this sample pool, outperforms passive management.
lLarger endowments outperform the smaller ones.
Endowments overweight assets that they the ability to actively manage
exceptionally.
Weaknesses and Limitations
The mathematical computations are difficult to follow/understand.
Lots of room to explain, in layman’s terms, findings. Though the authors fails to
take that opportunity.
Data tables lack descriptors, making the data all but useless to those statistically
wired.
Other Comments
From what I understood, it makes sense that active management can account for returns
over asset allocation. The big institutions have the resources that enable them to do so.
Jon Luskin - MBA Thesis v4.docx Page 97
Assessing endowment performance: The enduring role of low-cost investing
Vanguard Group, October 2012
Type of Work: Statistical analysis
About the Author(s): Not for profit investment services
Summary of the Scope, Approach, and Research Method: Compared NACUBO
endowment study with own calculations from Morningstar
Summary of Key Findings or Insights
Posits that endowments would be better investing in low-cost traditional vehicles
as opposed to exotic alternatives.
Large endowments directly invest in alternatives, where half of small
endowments invest in funds of funds.
Using the low-cost method also created higher returns when adjusted for risk.
Weaknesses and Limitations
Fails to consider volatility of returns in analysis.
Secrets of the Academy: The Drivers of University Endowment Success
Josh Lerner, Antoinette Schoar, and Jialan Wang, 2008
Type of Work: Statistical study
About the Author(s): Josh Lerner is the Jacob H. Schiff Professor of Investment
Banking, Harvard Business School Boston, Massachusetts.
Antoinette Schoar is the Michael M. Koerner Associate Professor of Entrepreneurial
Finance, Massachusetts Institute of Technology, Cambridge, Massachusetts.
Jialan Wang is a doctoral student in Financial Economics, Sloan School of Management,
Massachusetts Institute of Technology, Cambridge, Massachusetts.
Summary of the Scope, Approach, and Research Method
Analyzes endowment returns relative other variables.
Summary of Key Findings or Insights
Says high portfolio returns are a function of endowment size and use of
alternatives.
Endowment size is a better predicator of return than allocation to alternatives.
Ivy league schools lead the way with allocation to alternatives, trailed by the
categories of those institutions with large endowments. Private schools barely
have alternative holding above average.
Suggests that ivy league returns are correlated to their level of available expertise,
given they the most experience investing in alternatives
This in part due to the large institutions ability to pay for such talent – upwards of
$30 million salaries in some instances.
Relationships and organizational structures set top performing endowments apart.
Smart Institutions, Foolish Choices?
Josh Lerner, Antoinette Schoar, and Jialan Wang, February 2005
Type of Work: Statistical study
Summary of the Scope, Approach, and Research Method: Statistical analysis
Summary of Key Findings or Insights
Jon Luskin - MBA Thesis v4.docx Page 98
Different classes of institutional investors have received different returns for
private equity investments.
Endowments show the highest return for this asset class, with the greatest ability
to forecast future growth. Other institutions tend to chase performance.
Endowment’s superior performance in private equity may be their earlier
access/selection of active managers.
The more successful private equity deals are from veteran managers.
Endowments being the first to invest in Private Equity, have the most experience,
and thus correlate to the highest returns.
Lower returns may be a function of inexperienced investment staff. As they
become more experienced, they leave lower positions for higher salaried
opportunities.
Banks, when running a private equity offering, have conflicts of interest that may
return a loss on private equity investment, but generate fees for the banks.
Private universities have the highest returns for private equity.
Data shows that funds of funds chase performance, and thus returns suffer. Banks
and advisors show a high tendency to chase performance.
Endowments invest in venture capital at a higher rate than buy out, and those
follow up funds perform better than follow up funds of other categories of
institutional investors.
Endowments are able to pick the best performing general partners.
The top 25 percent of endowments skew the entire class’s performance upwards.
Endowments of universities with higher rankings and high alumni giving have
higher returns.
Funds selected by investment advisors and bank perform poorly.
Weaknesses and Limitations
Mentions that the top 25 endowment skew VC performance, but does not go in depth to
the degree of which.
Other Comments
It is the resources of these optimally performing endowments that has them perform so
highly, not their allocation to alternatives.
Jon Luskin - MBA Thesis v4.docx Page 99
Appendix F: CSSO Net of Fees Estimate
Fees for AUM vary. Many portfolio managers will charge a rate that declines as AUM
increases. For example, a portfolio manager may charge 0.9% for the first million under
management, and 0.5% for the successive million under management.
Precise information as to CSSO’s net of fee performance was not available. However, for
certain years, CSSO’s AUM figures, as well as amount paid in fees were available. With
a little extrapolation, net of fee performance can be estimated.
CSSO’s 990’s provided the amount of fees paid to investment managers for years
2006 through 2010. The same 990s reported year start, and year end assets under
management. By dividing the dollar amount in fees paid by the year’s average of AUM,
one arrives at a percentage of AUM, expressed as the possible fees paid to money
managers. Due to the numerous variables ignored and inaccuracy of this technique, the
resulting fee calculation was halved in an effort to be conservative. The lowest fee
estimate was applied to years absent data.
Again, the process is surely inaccurate; halving the calculation undoubtedly
grossly underestimates the total amount of fees paid to outside money managers.
Jon Luskin - MBA Thesis v4.docx Page 100
CSSO 10 Year Performance Gross of Fees, and Net of Estimated Fees
Calendar
Year
Gross
Return
Investment
Fees, per
990
Year Start
AUM
Year End
AUM
Year Average
AUM
% Fees
of
Year's
Average
1/2
Estimated
Fees
Estimate
Return
Net of
Fees
2003
25.96%
0.35%
25.61%
2004
14.96%
0.35%
14.61%
2005
10.59%
0.35%
10.24%
2006
14.73%
$33,054
$ 4,507,840
$ 4,217,023
$ 4,362,432
0.76%
0.38%
14.35%
2007
9.25%
$29,834
$ 4,217,023
$ 4,276,003
$ 4,246,513
0.70%
0.35%
8.90%
2008
-33.31%
$24,285
$ 4,276,003
$ 3,279,451
$ 3,279,451
0.74%
0.37%
-33.68%
2009
29.58%
$20,041
$ 3,279,451
$ 1,940,385
$ 1,940,385
1.03%
0.52%
29.06%
2010
13.46%
$16,461
$ 1,940,385
$ 1,160,337
$ 1,550,361
1.06%
0.53%
12.93%
2011
-2.32%
0.35%
-2.67%
2012
11.23%
0.35%
10.88%
Annualized
Return
7.90%
7.50%
Total
Return
113.83%
106.15%
Table 36 - CSSO 10 Year Performance Gross of Fees, and Net of Estimated Fees
Jon Luskin - MBA Thesis v4.docx Page 101
Appendix G: CSSO’s Problematic Portfolio
Conflicts Of Interest
The literature review raises troubling issues that manifest when trading mutual funds:
sales loads,
39
stale dollar trading, and soft dollars (i.e. kickbacks) (Swensen 2005). The
sales load is essentially a wealth transfer from investor to broker.
The successful investor avoids fees whenever possible. The succesful broker,
however, looks to collect fees whenever possible. A portion of the mutual fund load (fee)
go into the broker’s pocket (Bogle 2007, Bernstein 2010, Malkiel 2012, Swensen 2005).
The frequency of CSSO’s portfolio manager trading, and the manager’s use of loaded
mutual funds, manifests the conflict of interest inherent in the broker/client structure.
Each trade executed generates income for the portfolio manager, to the detriment of
CSSO’s wealth. One could even make the argument that CSSO’s portfolio manager is
frequently trading not for the purposes of generating higher returns, but to generate more
fees for himself.
Stale dollar trading is the effect of arbitrage on a mutual fund closing price.
Mutual funds, unlike modern exchange traded funds (ETFs) are bought or sold at a price
specified at the day’s end. While the specifics of this arbitrage are beyond the scope of
this paper, know that a savvy arbitrager could use this phenomenon to his advantage,
extracting wealth for himself at the expense of the mutual fund shareholder. In this
instance, that mutual fund shareholder is CSSO.
Soft dollars are kickbacks that a broker receives from a mutual fund services
company for selling that company’s mutual fund. Money is extracted out of the mutual
fund shares, travels into the mutual fund company’s balance sheet, and from there, a
portion of that money moves to the broker’s pocket (Swensen). This equates to a smaller
investment return offered by the mutual fund.
To see another example as to how and why active management failed CSSO, read on.
Case Study of a Mutual Fund -Why do actively managed funds underperform their
benchmark?
CSSO’s portfolio manager is underperforming simple index funds. An analysis of one of
CSSO’s holding may explain why.
Consider the first holding listed on CSSO’s regular statement from its portfolio
manager: the Blackrock Equity Dividend Fund (ticker: MDDVX). As a point of
comparison, reference Vanguard’s Dividend Growth Fund Investor Shares (VDIGX).
The Vanguard fund has not only outperformed Blackrock’s fund by a slight margin, but
has done so with less volatility, and at a fraction of the expense ratio.
Naturally, any analyst can go back in time to make the observation, “but if you had done
in this instead…” The point here is that Vanguard functions as the low-cost purveyor of
investment products by which other investment products (read: mutual funds and
Exchange Traded Funds) are judged. CSSO’s portfolio manager originally entered into
39
A sales load is a fee charged for a mutual fund transaction. The more frequently loaded mutual
funds are traded, the more frequently these funds are charged.
Jon Luskin - MBA Thesis v4.docx Page 102
the position in 2009, and continues to purchases more shares (26 more times as late as
May 1
st
, 2013). A simple analysis at any point before any further purchases would have
revealed the fund’s underperformance relative the low-cost Vanguard option.
Holding
BlackRock Equity Dividend Fund
Investor A Shares
Vanguard Dividend
Growth Fund
Ticker
MDDVX
VDIGX
3 Month
5.83%
8.68%
1 Year
13.90%
17.33%
3 Year
12.29%
13.67%
5 Year
4.35%
7.46%
10 Year
10.07%
10.12%
Exp. Ratio
0.99%
0.31%
Standard
Deviation
13.17
12.2
Sharpe Ratio
0.91
1.07
12-1b fee
0.25%
None
Table 37 - Vanguard vs. Blackrock Fund Comparison
Further analysis shows that the BlackRock fund manifested substantial growth relative
the S&P 500 and large value benchmarks beginning mid 2004 until mid-2008. Its
performance since then has failed to keep up with the same benchmarks. With CSSO’s
portfolio manager originally entering into the position in 2008, this begs the question, “Is
CSSO’s portfolio manager chasing performance?”
With comparable products on offer, why did CSSO’s portfolio manager opt for
the more expensive, and poorer-performing, option? To rephrase the question, “CSSO’s
portfolio manager is paying more to get less in way of investment returns. Why?”
One can only hypothesize, though the literature digest suggests some possibilities for this
seeming error in logic: soft dollar trading (read; kickbacks) (Swensen, Unconventional
Success: A Fundamental Approach to Personal Investment). The existence of a quarter of
a percent (0.25%) 12-1b
40
fee speaks to the inefficiency that is an investment in
BlackRock Equity Dividend Fund Investor A Shares.
To put it more clearly, a possible reason why the portfolio manager of CSSO’s
investments choose to continually invest in a poor performing mutual is because that
mutual fund company is paying that portfolio manager to do so via soft-dollars.
40
12-1b fees are marketing fees for the mutual fund. Essentially, a 12-1b fee is the cost for
advertising. Only some funds (read: expensive actively-managed funds) have these fees.